Insurance premium: What is it and how does it work?


In this part of our client education series, Insurance Business explains what an insurance premium is, how it works, and how it is calculated for different types of coverage. We encourage insurance agents and brokers to share this article with their clients to give them a deeper understanding of this crucial element of an insurance policy.

An insurance premium is the amount the policyholder agrees to pay in exchange for coverage. It guarantees financial compensation for the damages or losses they incur, as long as timely payments are made. Depending on the type of policy, the insurance company may require premiums to be paid monthly, semi-annually, or yearly.

Policyholders need to meet regular premium payments to keep their plans active. Failure to do so may void their policies and affect their future eligibility for obtaining coverage.

Insurance companies, in turn, use the premiums they collect to ensure that they have enough liquid assets to be able to provide financial compensation to policyholders in an event of a claim. If the amount of money they secure exceeds what they pay in claims costs and operational expenses, the difference is considered profit, also referred to as earned premium.

Some insurers also use premiums as an investment tool to generate higher returns. This strategy allows them to offset some of the costs associated with providing coverage and keep their insurance prices competitive.

While investing premiums may be a profitable move for many insurance providers, they are still required to maintain a certain level of liquidity to ensure that they have enough assets to pay for claims. The number is set by state insurance regulators.

Insurance premiums may also include service charges, depending on state insurance laws and the insurance contract. Any additional charges, however, must be itemized separately on the premium or account statement.

There are several factors that influence the price of an insurance premium, but generally, it is based on the policyholder’s risk level. This means that the more risks they pose to the insurer, the higher their premiums will be.

Depending on the type of coverage, insurance companies use different parameters in calculating premiums. 

Auto insurance

Different car insurance providers use different metrics in determining how much risk a motorist poses to them. These include driving-related factors such as traffic violations and type of vehicle, which carry a huge weight in calculating premiums, and personal attributes, including gender and marital status, which are considered not as essential.

Here are some of the most common factors auto insurers take into consideration when determining insurance rates, according to the Insurance Information Institute (Triple-I). 

  • Driving record: Auto insurers view a poor driving record as an indication that a motorist is more likely to file a claim in the future. As a result, at-fault accidents can drive up rates considerably.
  • Mileage: The more a person drives, the higher the likelihood that they may get into an accident, which can raise insurance premiums.
  • Residence: Policyholders who live in areas with high rates of crime and accidents will likely pay higher premiums than those who reside in safer locations.
  • Vehicle type: How much a car costs, how expensive it is to repair, how powerful the engine, its safety features, and how prone it is to theft are among the factors that have a major impact on car insurance premiums.
  • Age: Because a person’s age correlates with driving experience and the risk of getting involved in an accident, young drivers often pay the highest auto insurance rates.
  • Gender: Statistically, male drivers are more likely to get involved in accidents than female motorists, pushing up the premiums they need to pay.
  • Credit rating: Car insurance companies in most states use credit-based insurance scores to help determine premiums as these providers often believe that policyholders with high ratings tend to file fewer claims than those with lower credit scores.
  • Level of coverage: Comprehensive policies require higher premiums than basic plans but offer broader protection.

Home insurance

Home insurers consider a range of parameters when determining premiums, the biggest of which are the home’s location and the cost of a rebuild. Here’s how these and other factors impact the cost of home insurance premiums.

  • Address: The premiums for homes in disaster-prone and high-crime areas are higher compared to those in safer neighborhoods. To determine in which type of area a home is located, insurers often track the volume, kinds, and cost of claims in each zip code.
  • Rebuilding cost: Higher-priced homes cost more to insure as they are also more expensive to rebuild or repair. Most insurance companies use an insurance-to-value evaluator to calculate rebuilding costs based on several factors, including the house’s construction, square footage, and the number of floors.
  • The home’s age: Older and vintage houses have higher insurance costs as these often have features and construction materials that are costly and difficult to replace.
  • The home’s claims history: If homeowners have a history of filing claims, even minor ones, this may indicate a greater future claims risk for the insurance company. This drives up home insurance premiums.
  • Homeowners’ credit history: Just like with auto insurance premiums, home insurers in some states use a person’s credit-based insurance score to determine the likelihood that they may file a claim in the future.
  • Homeowner’s marital status: Married couples typically pay a lower insurance premium than their single counterparts as home insurers also perceive them to be low risk.

Other factors that may influence home insurance rates include:

  • Level of coverage
  • Deductible amount
  • Distance between the home and a fire hydrant or a fire station
  • Distance from water
  • Roof material
  • Pets
  • Attractive nuisances, including swimming pool, playground equipment, and trampoline, which increase liability potential

Life insurance

All the variables that can affect a person’s life expectancy also have an impact on life insurance premiums. These include:

  • Age
  • Gender
  • Occupation
  • Medical history
  • Smoking status
  • Hobbies

Historically, rates tend to be higher for men because they often have a shorter life expectancy than women. Certain professions – including truck drivers, construction workers, and law enforcement officers – also expose a person to a higher risk of fatal injuries, pushing up premiums. The same with involvement in extreme and adventure sports.

Prices may also vary depending on the insurer and the type of policy. Permanent life insurance policies, for instance, have higher premiums because these provide lifetime coverage compared to term life plans, which offer financial protection only within a set term.

Health insurance

Health insurance companies can only account for five factors when determining premiums under the healthcare law, according to the healthcare exchange website Healthcare.gov. These are:

  1. Age: Premiums can be up to three times higher for older people than for younger ones.
  2. Location: Differences in competition, state, local regulations, and cost of living also impact health insurance rates.
  3. Tobacco use: Insurers can charge tobacco users up to 50% more than those who do not smoke.
  4. Individual vs. family enrollment: Insurance providers can also charge more for a plan that also covers a spouse and dependents.
  5. Plan category: The different plan categories – Bronze, Silver, Gold, and Platinum – which indicate how the costs are split between the policyholder and the insurer, affect insurance premium prices.

The government website also noted that states can limit how much impact these factors have on insurance rates but prohibited them from using medical history and gender in calculating premiums. You can check out how health insurance plans work in the US and in different regions of the world in our health coverage guide.

There can be a massive difference between how much policyholders pay on premiums, depending on their personal circumstances and a range of insurance-related factors. But there are also several practical ways for them to save on premium costs. Here are some of them:

1. Comparing insurance rates

Because each person’s profile and circumstances are different, there is no single policy that is the cheapest for everyone. An insurance provider that offers the cheapest policy for one person might be the most expensive option for another. The only way for someone to ensure they are getting the lowest premiums possible is to compare insurance rates. This can be done through various insurance comparison websites that are easily accessible online.

2. Taking advantage of discounts

Insurance providers offer a range of discounts, which policyholders can take advantage of to reduce their annual premiums. These include:

  • Bundling of auto policies with homeowners’ or renters’ insurance
  • Insuring multiple vehicles in a single policy
  • Maintaining a clean driving record
  • Paying premiums in full instead of monthly instalments
  • Installing security and safety features in homes and vehicles
  • Being a member of professional organizations or affiliate groups

3. Skipping the unnecessary coverage

Insurance companies offer a range of coverage options that impact how much premiums will cost. Industry experts suggest ditching the coverage that policyholders might not need to reduce rates. For those who are already covered by health insurance, for example, they can remove or reduce medical payments coverage from their auto insurance plans to cut costs.

4. Maintaining a good credit rating

In most states, insurers use a person’s credit score in calculating car and home insurance premiums. This is done because there is a correlation between a person’s credit rating and the chances of filing claims. Therefore, keeping one’s finances in check can help policyholders save on insurance costs.

5. Raising your deductible

A higher deductible means policyholders will pay lower premiums. But this also increases the amount they need to pay before their insurer picks up the tab in the event of an accident or loss. This is why it is important for policyholders to be mindful of the costs when taking this route to make sure they have enough saved up in case of an emergency.

6. Shopping around when it’s time to renew

Unless they are purchasing a term life insurance plan, which locks in a monthly rate for the full policy term, the premium amount usually is not set in stone. Most policies last for six months or a year, at which point the insurer will re-evaluate their risk level which may impact insurance rates. Because of this, experts advise policyholders to review their coverage every time it renews and shop around. A good way to find the best rates is to get at least three different quotes and go for the one that offers the best value for their money.

Premiums and deductibles are two of the major out-of-pocket costs associated with insurance, which is why they may sometimes be confused with one another.

While an insurance premium is the amount a policyholder pays in exchange for coverage, a deductible is the amount the insured needs to pay for damages before coverage kicks in.

To illustrate, suppose a homeowner has a $500 deductible for the dwelling coverage on their home insurance. If a storm causes $5,000 worth of covered damages to their house, they will need to pay the $500 deductible for repairs while the insurance company covers the remaining $4,500.

One important thing to note is that the higher the deductible, the lower the insurance premium, and vice versa. Because of this, choosing a higher deductible may be a good way to reduce insurance costs, as long as the policyholder can afford to pay the out-of-pocket expenses.

A single policy may also have multiple deductibles as each coverage may have its own deductible amount. The only exception is health insurance, where plan holders usually need to meet a single deductible for an entire calendar year.

Almost all insurance policies come with a deductible, except for life insurance, where the beneficiaries receive a tax-free lump-sum payment after the policyholder dies.

You can find more definitions of common insurance industry terms in our jargon guide.

Are there other aspects of insurance premiums you want to discuss? Do you have additional tips on how policyholders can save on insurance costs? Chat us up on the comments section below.



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