Total Insurance Costs and the Frequency of Premium Payments

Abstract

While high premiums have made most purchasers of insurance cost conscious, little attention has been paid to the real cost of protection and the advisability of remitting the premium in multiple payments. Multiple payments have a major advantage over single premium payments in that the insured has the use of productive funds for a longer period of time. Offsetting this advantage, however, are the insured's additional handling costs and the premium surcharges associated with multiple payments. This paper develops a model which enables the policyholder to select that number of payments which will minimize his total real insurance costs. It explores the theoretical aspects of developing such a model as well as investigating its empirical applications. The purpose of this paper is to consider the most appropriate mode of premium payment for insurance protection. From the standpoint of total costs, should insurance be purchased by the owner and concurrently offered by the insurance companies on a weekly, monthly, quarterly, semi-annually, or annual basis? The selection of the appropriate method of paying for insurance protection is more important today than at any previous time. The public has become insurance conscious as settlements in damage suits have risen and laws have been enacted which virtually require the purchase of some forms of insurance. In addition, the general economic prosperity has given the business community and the majority of the populace material Richard L. Meyer, Ph.D., is Assistant Professor of Finance in the University of South Florida. Fred B. Power, M.Ed., is Assistant Professor of Finance, in the University of South Florida. This paper was submitted in December, 1972. The authors wish to express their appreciation to Professors James R. Longstreet and Peter Kares of the University of South Florida for their valuable comments. wealth which they desire t o protect. Thus, the total cost of insurance protection has become a major expense item for individuals and businesses alike. Other important factors relative to the selection of the correct mode of premium payment have been the steady rise of interest rates paid on accumulated savings and the expansion of consumer credit. Thus, the opportunity cost of paying the insurance premium is higher now than has been true in the past. The above factors necessitate the consideration of an appropriate mode of payment from the viewpoint of both the insured and the insurance company. This study has three purposes: (1) to develop a model for determining the optimal number of payments a policyowner should choose;' (2) to determine how much of a penalty the insurance company should charge an owner for multiple payments; and (3) to integrate the two other 1 The model developed here is a variation of the traditional economic order quantity (EOQ) model demonstrated by Arthur Snyder in Principles of Inventory Management, Financial Executive (April, 1964).