Insurance Premiums Explained

Posted by in Insurance | Updated on August 25, 2022

Insurance contracts are among the most complex legal agreements in ordinary life. Understanding your insurance policy is very important so you understand what is and isn’t covered, and the premiums due. Read on to learn what is an insurance premium.

What is an Insurance Premium?

An insurance premium is a sum of money you pay to an insurance company in exchange for having an insurance policy. Premiums are paid regularly and can cover many different things, including:

  • cars 
  • healthcare costs
  • houses 
  • life.

Insurance premiums vary based on numerous different factors, but one of these is coverage. Generally, a policy that covers more events, or offers a higher maximum payout has a higher premium. Thus, it is important to understand your needs so you do not end up paying higher premiums for benefits you don’t need.

How Insurance Premiums Work

After you sign the contract for an insurance policy, you have to begin paying insurance premiums to activate your coverage. 

After that, if you pay your insurance premiums in advance you won’t have any problems. However, if you pay the premium late, your coverage may be reduced or canceled. 

Make sure you fully understand the conditions laid out in your policy. When it comes to the frequency of premium payments, insurance companies usually offer several options depending on the policy:

  • monthly 
  • quarterly (four times a year)
  • bi-annual (twice a year)
  • annual

You should choose the premium payment schedule that best matches your income and spending patterns.

The other important factor to consider about insurance premiums is the amount. Insurance companies use sophisticated statistical models to assign different risk levels to different customers. 

For customers deemed to be at lower risk, the company offers low premiums. For customers, that it deems high-risk, an insurance company may charge very high premiums, or refuse coverage entirely. 

There are many different factors that an insurance company uses to decide what premium to charge you. A few of these factors are:

  • Age: Young adults are generally considered at higher risk of being involved in car collisions, so insurance companies charge higher premiums for young drivers. On the other hand, the opposite is true concerning life insurance.
  • Policy type: Different kinds of events have different probabilities of happening. There are also different expenses associated with those events. For example, cars spend a lot of time at high speed and are expensive to replace, so auto insurance is among the most expensive products. On the other hand, houses are not subject to as much constant risk, so even though they are more expensive to replace than cars, home insurance tends to cost less than auto insurance.
  • Area: A house that is on the Florida coast is much more likely to suffer hurricane damage in a given year than one in Vermont. So a policy with flood or total loss coverage is likely to cost more in Florida than the equivalent cover for a similar house in Vermont.
  • Previous claims: Insurance companies want to discourage people from making frequent claims because it is unprofitable for them. To achieve this, policies usually include increases in premiums every time you make a claim. Also, for some types of risks, previous behavior is an indicator of increased risk in the future (e.g. multiple car collisions) resulting in higher premiums.

Types of Insurance Premiums

There are different types of insurance policies, which cover different kinds of events. A few different types are outlined below.

Auto Insurance

Auto insurance relates to automobiles. This can include cars, trucks, and motorcycles. 

Auto insurance premiums vary widely, depending on the age of the driver, the value of the vehicle, the area in which it spends the most time, and many other factors. 

If you are wondering how to get car insurance, you can read more here.

Life Insurance

A life insurance policy pays out a set amount of money to beneficiaries that you choose in the event of your death. Life insurance premiums vary widely depending on your age, the maximum payout amount, your health, and even your lifestyle. 

Generally, young people pay lower life insurance premiums than their older counterparts. In addition, many life insurance policies offer bonuses or lower premiums for desirable behaviors such as regularly visiting a gym, or regular health checkups. 

Read more here on how life insurance works.

How Insurance Premiums are Calculated

Insurance premiums are generally based on many factors. These include age, policy type, area in which the policy is active, previous claims made by the customer, and many others. All of these factors are entered into highly sophisticated statistical models that determine the premium. 

These mathematical models are developed and managed by highly-trained statisticians called actuaries. An actuary is a person who has the expertise to assess and manage the risks associated with financial investments, insurance policies, and other profitable activities that are subject to complicated risks.

Actuaries use a combination of tools from statistics, economics, and computer science to create computer models that can quantify risk. In short, an actuary is someone who uses scientific tools to understand and manage risk.

When viewed from the perspective of the insurance company, the premiums you pay for your policy can fall into one or both of the following categories:

  • Underwriting fund: Underwriting is the process of actually providing insurance cover. The premiums you pay for your policy are used to pay out to customers who make successful claims. If the company collects more money in premiums than it pays out in claims then it is profitable.
  • Investment fund: Some insurance companies multiply their profits by investing a portion of the premiums customers pay. If they get a positive return on their investments, then they increase their profitability without having to get any more customers. 

Insurance Premiums FAQ

The questions below often come up when discussing what is an insurance premium.

What Factors Affect Insurance Premiums?

The statistical models that determine your insurance premiums take into account dozens or even hundreds of different factors that apply to you and your environment. Premiums also vary based on the details of your policy, such as policy type, the maximum payout, amount of coverage, and how many times you have previously claimed.

What Do Insurers Do With Your Premium?

Insurers use premiums to pay out successful claims to their customers. Some companies also increase their profitability by using a portion of their customer’s premiums to invest in financial assets on the stock market or elsewhere. When these investments are profitable, the company can increase its profitability without having to attract extra customers. 

In this situation, the company still needs to keep a certain amount of money available as cash or cash-like (liquid) assets so it can quickly pay successful claims. State and federal regulations specify the minimum amount of liquid assets that an insurance company must hold for a given number of policies.

Read More

Final Thoughts 

Having a good understanding of what is an insurance premium is important. An insurance premium is the monthly, quarterly, or annual cost of having an insurance policy. Premiums are calculated individually for every customer depending on age, the area in which the policy will be active, the number of previous claims, and other factors. Insurance companies use collected premiums to pay successful claims. Some companies invest a portion of the premiums they collect to increase their profitability.

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