Definition and Use of the Frequency-Severity Method by Insurers

The Frequency-Severity Method: What Is It?
An actuarial technique called the frequency-severity approach is used to estimate the average cost of a claim as well as the anticipated number of claims that an insurer would receive over a specific time period.

The frequency-severity technique estimates the average number of claims and the average cost of each claim based on previous data. The average cost of a claim is multiplied by the average number of claims.

Knowing the Frequency-Severity Approach
The number of claims that an insurer expects to occur during a specific time period is referred to as frequency in the frequency-severity technique. A high frequency indicates that many claims are anticipated to be made.

Severity refers to the cost of a claim. A high-severity claim is more expensive than an average claim, and a low-severity claim is less expensive than the average claim. Average costs of claims are estimated based on historical data.1

For instance, consider a prospective home buyer considering the purchase of a beach house in Miami. This part of the Florida coast averages one hurricane per year. With the potential for complete destruction so high and so frequent, the frequency-severity method would indicate that an insurance company should avoid underwriting a policy for this beach house.

Rather, depending on the kinds of policies they provide policyholders, insurers create projections about the number of claims they could anticipate and the cost of those claims. One way that insurers can create models is by using the frequency-severity technique.

The quantity of claims that an insurer anticipates seeing is referred to as frequency. A high frequency indicates that a significant volume of claims is anticipated.

Historical cost data may be used to determine the average cost of claims. The frequency-severity technique is less affected by more turbulent recent times since it considers prior years when estimating average expenses for future years. This indicates that, according to more recent years, it is not dependent on loss development elements.

This also implies that the approach responds to volatility rises more slowly. An insurer that offers flood insurance, for instance, may respond more slowly to a rise in the frequency or severity of flood damage claims brought on by recently elevated water levels.