Understanding Insurance Premiums: Definitions, Calculations, and Types

What Is an Insurance Premium?

An insurance premium is a payment made by individuals or businesses to maintain coverage under an insurance policy, which protects against various risks. Premiums are required for health, auto, home, and life insurance policies, among others. Understanding how these premiums are calculated, based on factors like coverage type and personal risk factors, can help you make informed insurance decisions and potentially save on costs.

Key Takeaways

• Insurance premiums are regular payments made by policyholders to keep their insurance coverage active, covering a variety of risks and potential losses.
• Factors affecting insurance premiums include the type of coverage, policyholder’s age, location, claims history, and overall risk evaluation.
• Insurers usually invest collected premiums to generate higher returns, which can help keep insurance prices competitive.
• Actuaries play a critical role in calculating insurance premiums by analyzing risk using mathematics and statistical models.
• Shopping around for insurance policies can help consumers find more affordable premiums by comparing different insurers and coverage options.

Understanding How Insurance Premiums Operate

When you sign up for an insurance policy, your insurer will charge you a premium. This payment keeps your policy active. Policyholders may choose from several options for paying their insurance premiums. Some insurers allow the policyholder to pay the insurance premium in installments—such as monthly or annually—while others may require an upfront payment for each full year before any coverage starts.

Premium costs depend on various factors like:

• The type of coverage
• Your age
• The area in which you live
• Any claims filed in the past
• Moral hazard and adverse selection

Insurers earn money by collecting premiums and investing them in safe options like bonds. Once a company earns a premium, it becomes their income. Unearned premiums are liabilities since insurers must cover claims against the policy.

Factors Influencing the Calculation of Insurance Premiums

Insurers consider several factors to decide the premium amount for each coverage set. Some factors, like age, are common across insurance types, while others vary by coverage.

Determining Auto Insurance Premiums

The main factors in determining automobile insurance premiums include your driving record, your geographic location, how often you use your car, the type of car(s) being insured, your gender, your credit record, and your age. Another consideration is the type of insurance coverage you purchase, include the limits on coverage amounts and the deductibles.2
Insurance Information Institute. “What Determines the Price of an Auto Insurance Policy?”

For example, the likelihood of a claim being made against a teenage driver living in an urban area may be higher than a teenage driver in a suburban area. Similarly, younger and newer drivers carry a greater risk of being involved in an accident than older, more experienced drivers. In general, the greater the risk associated, the more expensive the insurance premiums.

Calculating Life Insurance Premiums

In the case of a life insurance policy, the major factors the company looks at in pricing coverage are an insured’s risk of mortality, the interest it expects to earn by investing your premium, and the expenses it will incur.3 The age at which you begin coverage will determine your premium amount, along with other risk factors (such as your current health). The younger you are, the lower your premiums will generally be. Conversely, the older you get, the more you pay in premiums to your insurance company. High-value policies will also carry a higher permium.

Since life insurance covers a period of many years, there may be more flexibility in how you pay your premiums. A few insurers may offer premium cash flow payment plans. These plans allow the policyholder to pay the premium in small intervals. Some policyholders might also use premium financing to pay for expensive premiums, but there is risk involved with this process.

Understanding Health Insurance Premiums Under the ACA

The Affordable Care Act (ACA) of 2010 spelled out a number of rules that regulate how insurance company can set determine the premiums they charge. For companies that offer coverage through the ACA Health Insurance Marketplace, there are five major factors that insurances can use to set rates: age, category of insurance plan, your geographic location, tobacco use, and whether the enrollment covers an individual or a family. Marketplace plans must also charge men and women the same rates, and cannot take your health history into account.4

Insights Into the Premium-Setting Process

Insurers hire actuaries to set risk levels and premiums for individual and group policies. Despite new algorithms and AI, human actuaries remain crucial in pricing insurance. Actuaries use mathematics, statistics, and financial theory to analyze the economic costs of the potential risks in a policy or group of policies. They rely on computer models to analyze previous experiences and anticipate future outcomes so they can set premiums that allow the insurance company to make a profit while charging competitive prices.5

Once premiums are determined, insurers use this revenue from their customers to cover liabilities associated with the policies they underwrite. They may also invest premiums to generate higher returns. This can offset some costs of providing insurance coverage and help an insurer keep its prices competitive in the marketplace.

While life insurance premiums are generally set for the lifetime of the insured, actuaries for health and auto insurers adjust premiums on a regular basis. Insurance premiums may increase after the policy period ends. The insurer may increase the premium for claims made during the previous period if the risk associated with offering a particular type of insurance increases, or if the cost of providing coverage increases.

While insurance companies may invest in assets with varying levels of liquidity and returns, they are required to maintain a certain level of liquidity at all times. State insurance regulators set the number of liquid assets necessary to ensure insurers can pay claims.

Strategies for Finding Economical Insurance Premiums

Most consumers find shopping around to be the best way to find the lowest insurance premiums. You may choose to shop on your own with individual insurance companies or through aggregation sites that offer prices from multiple insurers. It’s fairly easy to obtain quotes by yourself online.

For example, ACA enabled uninsured consumers to shop for health insurance policies on its marketplace. Upon logging in, the site requires some basic information, such as your name, date of birth, address, and income, along with the personal information of anyone else in your household. You can choose from several options available based on your home state—each with different premiums, deductibles, and copays—the policy coverage changes based on the amount you pay. Providers will base premiums on the enrolee’s state, the individual’s history, and other factors.6

The other option is going through an insurance agent or broker. They tend to work with a number of different companies and can try to get you the best quote. Many brokers can connect you to life, auto, home, health, liability, and other insurance policies. However, it’s important to remember that some of these brokers may largely be motivated by the sales commissions they earn.

What Do Insurers Do With the Premiums?

Insurers use the premiums paid to them by their customers and policyholders to cover liabilities associated with the policies they underwrite. Most insurers also invest the premiums to generate higher returns. By doing so, the companies can offset some costs of providing insurance coverage and help keep its prices competitive.

What Are the Key Factors Affecting Insurance Premiums?

Insurance premiums depend on a variety of factors, including the type of coverage being purchased by the policyholder, the age of the policyholder, where the policyholder lives, and the claim history of the policyholder. Insurance premiums may increase after the policy period ends or if the risk associated with offering a particular type of insurance increases. The insurer may also change if the amount of coverage changes.

How Often Do You Pay Insurance Premiums?

Most insurance companoes allow you to pay your premiums monthly, quarterly, or annually.7

What Is an Actuary?

An actuary assesses and manages the risks of financial investments, insurance policies, and other potentially risky ventures. Actuaries assess particular situations’ financial risks, primarily using probability, economic theory, and computer science. Most actuaries work at insurance companies, where their risk-management capabilities are particularly applicable in determining risk levels and premium prices for a given insurance policy.

Conclusion

Understanding insurance premiums is crucial for managing personal and business risks. Premiums are determined by various factors including the type of coverage, the policyholder’s age and location, and past claims history. Insurers use actuarial assessments to set these premiums, balancing risk management with competitive pricing. Shopping around can lead to more affordable premiums, and different payment options may cater to the policyholder’s financial situation. Overall, knowing how premiums work and being proactive about comparing options empowers consumers to make informed insurance choices.