Frequency-Severity Method

Let’s talk about the “what if” game. On one hand, it can lead us to dream bigger: What if we get that grad degree and become an expert in our field and end up winning the Nobel Peace Prize for our work? On the other hand, it can cause us to question our past decisions: What if we hadn’t broken up with so-and-so with the big blue eyes last year?

And on the other other hand, it can determine how much we pay for insurance.

That’s right: when actuaries are determining how much we’re going to pay for stuff like home and auto insurance, they play a (carefully crafted and historically accurate) game of “what if,” and they do it using something called the “frequency-severity method.” In a nutshell, frequency = how often something bad is likely to happen, and severity = how much it costs to fix. The higher the number of claims an insurance company expects, and the more expensive those claims are likely to be, the more we’re going to pay.

So if, for example, we live in a high-crime area and park our car on the street, we might pay more for car insurance than someone who lives in a lower-crime neighborhood or can park their car in a garage. The insurance company expects street parkers in high-crime areas to file more claims, which means they have to shell out more money.

Similarly, if we go against all advice and decide to build our dream home on the banks of a river that floods all the time, we’re going to end up paying more for home insurance than someone who lives in a flood-free area. The frequency of flood events in our area is higher than in other areas, and the severity of flood damage can be…you know…severe.

The frequency-severity method is one way insurance companies can help make sure they’re collecting enough dough to pay for the potential claims of their customers.