How the Insurance Company Determines your Groups Premium

With the growing insurance premiums in most lines of business, it is necessary to come to a basic understanding of how insurance premiums are determined. By the public outcry, one pictures a bunch of insurance executives sitting in a yacht, sipping cognac, and dreaming up ways to gouge the public. While that scenario probably has occurred at times, the truth is that insurance premiums are usually determined by more scientific methods. The scenario is more likely a team of accountants and actuaries, huddled in front of computers and guzzling coffee. Understanding the factors involved in determining premiums can help tone down the hysteria and unfair attacks and even help you lower your own premiums, by understanding what factors put you at more risk.

The first thing to remember about insurance is that most plans are run by businesses. Businesses are created to make profits. Although insurance companies participate in charitable activities, they are not charities. The second thing to remember is that the insurance industry is a most unpredictable venture. No one can forecast a new disease ahead of time, or know for sure how many bad hurricanes will hit the coast a year or two in advance. Insurance companies are gamblers. And the chips on the table are your premiums.

Insurance is the spreading of risk among a large group in order to keep the expenses of individuals in the group lower, when the individual experiences a loss. When determining premiums, the number of members in the pool and the predictability of how much risk is within the pool are the main factors considered. With luck, you should never expect to get your money’s worth out of the premiums you pay. But if your house burns down, you will be grateful you kept your payments up.

In the case of property insurance, the chance that a large group of homes in a coastal area will be damaged by hurricanes, more than once, is greater than it is for a group of homes in a non-coastal area. But reasonably, not every home in that area would be damaged. So the premiums would be calculated based on the percentage of homes out of all the insured homes that were predicted to be damaged in a normal hurricane year. If 1000 homes are covered, and an area is predicted, based on past experience and future hurricane predictions (think global warming), to sustain 2% damage, the basis of the premium would be the projected insurance payouts for 20 homes divided among the 1000 homes that are covered. Ideally, the wider the area and the more members in the pool, the cheaper the insurance would be. But those living inland tend to object to the high costs associated with the coastal coverage, shop around for better deals and get insurance in a lower risk pool for a lower premium. This leaves the coastal homeowners paying more because their pool, without the lower risk houses, becomes riskier.

Many formulas are applied to individual premiums based on individual risk. How close the house is to a fire department and water source, construction materials, and age of a house are used. Discounts are given for risk-reducing factors, such as alarm systems and deadbolt locks. Premiums are lower when the member opts for a higher deductible because not only is a higher portion of the damage paid by the member, but it discourages claims for smaller damages.

Sometimes, a change in the usual predictions can cause a jump in premiums. When AIDS appeared on the scene, insurance companies took a bath. When the predictions pointed to an AIDS epidemic, premiums rose. Similarly, when the public became aware of the dangers of mold, companies had to account for those payouts in their premium calculations.

Another factor that determines premiums is overhead. It costs money not only to pay your hospital bill, but to enroll members, process your claim, audit your hospital to make sure the bills are fair, market their products, comply with state insurance administrations, pay taxes, detect and prosecute fraud, and the myriad of other functions necessary to run a business. A company that executes more business online, doesn’t place Super Bowl ads and has few branch offices will inject lower overhead costs into the premium.

A little known cost that insurance companies have is insurance premiums. To protect from large scale disasters, insurers pay premiums to re-insurers. These are companies, such as Lloyds of London, who offer coverage for catastrophic losses to the insurance companies themselves. These re-insurance costs affect your individual premiums as well. But they may keep your company from going bankrupt when a major catastrophe hits.

You may be shaking your head at this point thinking that the US had a “good” hurricane year and yet the premiums went up. Given that past experience is a factor, shouldn’t the rated be lower the following year? The answer is “possibly”. Auto insurance rates were predicted to drop in 2007, based on lower claims experience. Time will tell. But other issues in play have a huge affect on the premiums.

Because of the unpredictability of risk, insurance companies maintain “reserves”. Contrary to popular belief, the premiums paid by the members rarely cover the costs of the insurance payouts. States require companies to maintain a pool of money, at a specified level, in order to cover higher than expected losses. If a company’s reserves are low, it must increase the premium to ensure that the reserve limit is covered, or say goodbye to its insurance license. Reserve money is invested. So if the returns are low, premium increases are a way to get them back up to the appropriate level. It takes a while for these factors to balance out.

One major complaint about insurance companies is when the investment earnings are reported. People see that as money that can be used to offset the higher premiums. Often they do. But the measure of a strong insurance company is when its earnings and reserves are higher than its payout. When the reserves and earnings are high enough, the premiums do come down. Keeping premiums high is not good business. Lower premiums attract more customers, which increases the risk pool and keeps the reserves higher. So when your insurance company reports high returns on its investments, it’s unfair to call the companies greedy. In any other business, it’s called profit, or good old American capitalism at its best. And, as stated up front, profit is why insurance companies go into business in the first place.