When the unearned premium is reduced because an insured cancels a policy mid-term, what is this method called?

• A. Short rate
• B. Pro rata
• C. Earned premium
• D. Refund penalty

Answer: (A)

When a policy is canceled before the term ends, insurers often apply a cancellation method that imposes a penalty for ending early. This is the short-rate method. It uses a short-rate schedule to determine how much unearned premium to refund, which typically yields a smaller refund than if you simply refunded the unused time on a proportional basis. The idea is that the insurer has already provided protection for part of the term and incurs fixed costs and risk exposure, so a portion of the unearned premium is kept as a cancellation penalty.

By contrast, pro rata would refund the unused portion exactly in proportion to the time remaining, with no penalty. Earned premium refers to the portion of the premium that has already been earned by providing coverage, not the method used to calculate mid-term cancellations. “Refund penalty” isn’t the standard method name used here.