How Insurance Premiums Are Calculated

What insurance companies do basically is that they bear the risks that people have, for a price. So it becomes rather important to be able to price these risks as accurately as possible.

Since risk always involves uncertainty, as we are dealing with probabilities here, the likelihood that an event will happen, we’re never going to know with any certainty whether an insured risk is going to occur in any given time period, but we can get a working idea of how likely it would be generally.

This involves some considerable work indeed, and insurance companies do have a staff of experts, called actuaries, who devote themselves to some extremely complex calculations in looking to arrive at as accurate of a set of predictions for a given insured situation, which then forms the basis of the amount of money that is charged to cover given risks.

There is no absolute requirement for accuracy here, as this is done on a best effort basis, but an insurance company’s profitability and even the existence of the insurance industry at all is going to depend fundamentally on a sound understanding of the probability of events under certain circumstances.

There are actually two major components to this, the overall risk assessment of an event and a specific one related to the risk that certain clients will experience an insured event, a claim in other words.

Broad Classifications Of Risk

In a sense, the broadest calculation that insurance companies need to look at is their overall premiums versus their expected claims over a given period. So for instance an insurance company needs to take in more overall then they pay out, plus their associated costs, and their desired profit margins.

This is the case for any business of course, they want to make a profit, and they want to price their goods or services to allow them to do so. There’s also the economics of the market at play though which is why they also need to define these risks more specifically, as this will make the whole thing more efficient.

So let’s say an insurance company is charging enough to make a profit, and this can be looked at from both a top down method, just looking at the business as a whole, or from a bottom up perspective, making sure each class of insurance satisfies this requirement, and if they do, then we know for sure that the business as a whole is doing so as well.

Since insurance companies don’t want to be offering unprofitable insurance lines, for instance if they were making money on life insurance but losing on car insurance they wouldn’t just say, well we’re making money overall so let’s not worry about losing on car insurance, they would seek to change or eliminate unprofitable lines.

There are two reasons why an insurance line wouldn’t be profitable, which is a lack of demand for it at its current price, or that it is priced too low. The normal forces of business apply to insurance as well, particularly competitive forces, but first and foremost an insurance company wants to make sure that they are at least setting themselves up for potential success by pricing their policies in line with the risk they are taking on.

So they look at their overall risk exposure and their exposure among the various lines of insurance they offer, to ensure that they are first taking in enough money in premiums to cover their business needs, and then look to refine these to improve the efficiency of their business and also put them in a more competitive position.

Specific Pricing of Insurance Policies

Ultimately though, they want to do their best to price each policy efficiently, which involves taking into account a lot of different factors that may apply to these specific policies.

Let’s say that an insurance company offered a flat rate for car insurance, not taking anything else into account. For some of these people, those with more expensive cars, and those who are in situations where more risk would be involved, a bad driving record for instance or living in a big city, this sort of pricing will be perfect for them, and people would flock to pay prices based upon average risk rather than ones priced to their higher risk.

The lower risk drivers aren’t going to want to pay average risk prices because in this case they would be paying too much, so they would go to other insurance companies for their insurance.

So our company would be left with just the clients that they would lose money on, and they would have to raise their premiums. As they do, the least risky drivers among their current clientele would leave, making another price increase necessary, and eventually they would have lost quite a bit of money while tweaking this and be left with the riskiest policies out there.

Now there are some insurance companies that to serve this segment, called the facility market, this is where the really bad drivers go to get their insurance, or people who have been convicted of offenses such as drunk driving, or even people who have had a lapse in insurance and are therefore considered to be more risky due to that.

That wasn’t our intention though when our company sought to get into the car insurance business though, we just ended up there because we didn’t price our policies based upon specific risk. So this is one of the reasons why insurance companies do this. If this was a monopoly, then they could get away with it, in spite of the system being unfair and a lot of people being unhappy,

This is one of the knocks against a state run insurance scheme, such as socialized health care, everyone pays into it from taxation but a lot of people pay more or way more of their share in regard to their risk, while some others pay less or way less.

Since some claim that health care coverage is a basic right, there’s at least an argument that the inefficiencies here are worth it, and even perhaps necessary, although these insurance schemes still struggle with looking to make this insurance at least a little more efficient.

It is hard to imagine something like car insurance being a basic necessity though, but some governments still look to socialize this and have things like no fault insurance where the safer drivers pay more and the less safe ones pay less. Aside from whether that’s a good idea or not, this would never work in the free market.

Drilling Down To Assess Risk

If you’re looking to get car insurance, then there’s going to be a number of things that an insurance company is going to want to look at, to decide how much to charge you. They want to come as close as practically possible to pricing this insurance correctly according to your individual circumstances.

So the kind of car you drive, how valuable it is, your age, how long you’ve been driving, how long you’ve had continuous auto insurance for, how much you drive, where you drive, where you live, your level of education, and other factors all go into the equation.

Insurance companies even account for the color of your car, where for instance red cars are associated with more aggressive drivers so you may pay more for driving one, and other colors may be more visible on the road so you may get a discount for that.

Insurance companies have even started to offer drivers the ability to install electronic devices in their cars to monitor various things that assist them in assessing each driver’s specific risks, and one day we may even see this being required.

Other types of insurance also are broken down by several risk factors, and what the insurance company is looking to do is to assign risk most accurately in order to best allow for clients to pay premiums proportionate to their individual risk assessments.

It’s true that this may involve some over generalizations, like for instance you may be a very safe and conservative driver even though you may drive a red car, and there also may be a number of other factors which may place you at less risk but the insurance company isn’t accounting for, or accounting for enough, but insurance companies are always looking to make this calculation as fair as they can make it because the success of their business depends on it.

As time has gone on and the insurance business has matured, the assessment of specific risk has become more sophisticated, but the way that insurance companies use these comparisons is always going to depend on broad data to a certain degree, the red car example is a good one here, and they are looking at large groups of people here when deciding these things generally, so there’s going to be some inefficiencies that emerge here.

Since insurance companies may price these specific situations differently, and this is one of the reasons why shopping around for insurance is such a good idea, and why we can see some pretty big differences between quotes from different insurance companies.

People must always be aware that if they don’t disclose something to an insurance company, or lie to them, and it gets found out later when a claim is made, then the insurance company will refuse to pay the claim. So while telling the truth may cost you more now, not doing so may lead to your paying for something for years and then ending up not insured at all when you need it.

Risk based pricing is something that allows for the fair and efficient pricing for insurance, and this can be a pain at times while shopping around, having to go through a fairly complicated process to even get a price for someone, but doing it this way is the only real way it makes sense to run an insurance company, and the extra time you spend doing all this can be very worthwhile in spite of the inconvenience.

Robert

Editor, MarketReview.com

Robert really stands out in the way that he is able to clarify things through the application of simple economic principles which he also makes easy to understand.