claim cost (frequency x severity) in health

Imagine you run a small clinic-coverage scheme for 1,000 members and you must set a fair monthly fee. The honest question is: across all those members, how much care will the scheme have to pay for next year? The answer breaks neatly into two pieces — how many claims happen, and how big each one is. That product is the claim cost, the heart of every health rate.

The formula is expected claim cost = frequency x severity. Frequency is how often a covered event happens per member (say, on average 4 doctor visits per member per year). Severity is the average cost per event (say 80 per visit). Multiply: 4 x 80 = 320 per member per year, or about 27 per member per month (often written PMPM, per member per month). Add other service categories — hospital, drugs, tests — each with its own frequency and severity, and you build up the total expected cost. The premium is then this claim cost, loaded for expenses, profit, and a margin for uncertainty.

Splitting cost into frequency and severity is powerful because the two move for different reasons and can be managed separately. A flu season or an aging group raises frequency; new expensive drugs or hospital price increases raise severity. When a health actuary investigates why costs jumped, the first step is almost always to ask 'was it that more people used care, or that each use cost more?' — because the fix, and the trend assumption, differs for each.