The Cost of Insurance: Anatomy of a Premium

The best way to understand what goes into your premium is to understand what insurers must face when they issue a policy: risk.

Insurers must accurately assess risk. For the most part, they do a pretty good job. If they didn't, they'd be broke in a couple years because the amount they paid out in claims would dwarf the amount they collected in premiums.

Insurers have developed complex formulas for determining the claims risk of a person. Every insurer has their own risk calculating algorithm, but there are similarities among all major insurers. (See below for the common factors.)

You may think you're not a big risk. And you may not be. Risk assessment isn't an exact science and sometimes it's downright unfair. "Why should I have to pay more for car insurance simply because I'm a guy? My wife thinks she's a Formula One driver, and drives like one, but she pays less for insurance just because she's a woman!"

It's Not Personal: Insurers Look at Trends

Good risk assessment relies on analyzing trends. Insurance companies employ number crunchers who assemble huge piles of data. They pore through it to see what the big trends are. For example, the data says men are more likely to speed and get in serious accidents. For you guys reading this, that doesn't mean you're necessarily Evel Kneivel behind the wheel-it just means that your chromosomal arrangement raises some initial misgivings.

People with bad credit are, historically, more of a claims risk. To use another example, the data says that people who smoke are more likely to need more frequent-and more expensive-hospital treatment than nonsmokers. Maybe you only smoke one cigarette a day and can quit anytime. To insurers, though, you're simply part of a mountain of evidence that says 'smoking = risk.'

The Pros and Cons of Pooling Risk

There is another component to assessing risk, and it seems even more unfair: other people.

Strange as it sounds, a certain percentage of your premium dollar goes toward the cost of insuring other people. This is what's called pooling risk, and it's what makes insurance work. If we all carried our own individual risk, we'd never get behind the wheel, never work, never start a business, and never build or buy a house. It would be too financially risky. But by spreading the risk amongst a lot of people, we can do these things. That's the benefit of pooling risk.

The flip side to distributing risk is that we have to pick up the slack for the riskier elements of the pool. Going back to the auto insurance example, we all pay a little extra because of young men's predilection for driving fast and recklessly. Regardless of our individual diets, we all pay higher health insurance premiums because of our society's fondness for nicotine, trans fats and high fructose corn syrup.

The bottom line, though, is that pooling risk works. We give up a little to get a lot more protection.

Finally, if you've got sticker shock, consider this: an insurance company's ability to accurately assess risk ensures that they'll be able to pay should you file a claim.

The Cost of Insurance: the Factors

Below is a list of some of the cost factors in auto, home, health and life insurance underwriting. This isn't a definitive list, but it comes pretty close to describing what insurers think about when they set the price of a particular policy. (These are not listed in order of importance.)

Homeowners insurance cost factors:

  • Your credit history/insurance score
  • Deductibles
  • Claims history
  • Size of home and surrounding structures
  • Local building costs
  • Natural disaster risk
  • Condition of heating, electrical and plumbing systems
  • Proximity to fire station/hydrant
  • Amount of crime in neighborhood
  • Home's construction, materials and architectural features

Auto insurance cost factors:

  • Age
  • Type of vehicle
  • Retirement status
  • Marital status
  • Driving record
  • Credit history/insurance score
  • Deductibles*
  • Education level
  • What you use your car for
  • Military service
  • Where you live/where you park
  • Whether you have had continuous coverage
  • Vehicle specifications
  • Claims history
  • Education level, grade point average (GPA)
  • Occupation

Health insurance cost factors:

  • Age
  • Occupation
  • Deductible and copay amounts
  • Previous denial of health coverage (within past 12 months)
  • Previous hospitalization (within the past 5 years (excluding pregnancy)
  • Ongoing medical treatments
  • Pregnancy
  • Smoking
  • HIV/AIDS
  • Heart attack
  • Stroke
  • Diabetes
  • High blood pressure
  • Depression requiring medication
  • Cancer
  • Asthma

Life insurance cost factors:

  • Age
  • Occupation
  • Amount of insurance-death benefit amount
  • Type of policy-permanent (also called cash value) policies generally cost more than term policies.
  • Hazardous hobbies-e.g., skydiving, mountain climbing, alligator wrestling
  • Previous hospitalization (within the past 5 years (excluding pregnancy)
  • Ongoing medical treatments
  • Pregnancy
  • Smoking
  • HIV/AIDS
  • Heart attack
  • Stroke
  • Diabetes
  • High blood pressure
  • Depression requiring medication
  • Cancer
  • Asthma

"What's a deductible?" In the event you file a claim, your deductible is the amount you pay before your insurer starts paying.

 

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