Premium

How is an insurance premium calculated?

Insurance providers collect premiums in exchange for accepting the risk of protecting a home, car, business, or whichever object of insurance. All their customers’ premiums get pooled together, and the insurance company pays claims out of this pool.

The first step in calculating premiums is predicting how large a pool the company will need. Insurance companies employ actuaries to make these calculations. Actuaries analyze mountains of data to figure out how much the insurance company should expect to pay for claims over the course of the next year (or several years).

Based on that information, the insurance company knows how much premium they need to collect in total to ensure that they’ll have enough cash to cover their customers’ losses — also known as the loss ratio.

Of course, not every insurance customer pays the same premiums. Individual premiums are calculated based on relative risk: customers who are very likely to draw from the claim settlement pool pay higher premiums than customers who are not likely to make any claims.

Basically: more risk for the insurance company equals higher premiums.

In deciding how much to charge each customer, insurers evaluate dozens or even hundreds of factors. Many of those factors are outside the control of the individual customer, which is part of why many people feel frustrated by seemingly random insurance premiums.

Every insurer has their own approach, but when it comes to home insurance, there are certain things that every home insurance company looks at when determining premiums:

• Location of the home. There are actually many factors rolled into one here, but the physical location of an insured home is a very important premium rating factor. For example, a home located on a floodplain is (obviously) at risk of being damaged by a flood, so insurers would charge higher premiums to insure it.

• Home’s proximity to fire protection. Fire is one of the most destructive risks a home faces, so being close to fire hydrants and fire halls helps lower premiums. This is not typically an issue for homes in cities, but rural homes may be many kilometres from fire protection.

• Replacement cost of property. Since the insurance company is agreeing to cover the cost of rebuilding or replacing insured property (homes, furniture, or anything else) they will charge higher premiums for more expensive property. This is part of why tenant’s insurance tends to be less expensive than homeowner’s insurance: tenants don’t need to insure the replacement value of their home, since they don’t own it.

• Age and type of in-home systems. Plumbing, HVAC, and electrical systems can all be factors in determining home insurance premiums. Old wood stoves present a fire risk, especially if they haven’t been maintained properly. Outdated electrical systems, like knob and tube wiring, increase the home’s risk of fire as well. Homes with well-maintained, modern systems may see lower premiums than homes with aging systems.

• Occupancy. Insurers usually charge lower premiums to owner-occupied primary homes. Vacation homes have a higher risk because they’re often empty, with no one present to respond to issues. Rental homes are riskier because the owner can’t control who is coming and going from the property.

• Age and construction of home. Old homes are at greater risk of suffering damage than new homes, so they’re often more expensive to insure. The style of construction is a factor, too; a solid concrete building may be more expensive to build or repair than a wood frame structure.

• Liability factors. Since home insurance includes liability coverage, insurers will charge higher premiums for homes that are at greater risk of having liability claims. For example, a house with a tall balcony that has no railing would be at risk of having a guest fall and seriously injure themselves, so the insurance company would charge a higher premium (or more likely, ask that the homeowner install a railing).

Similarly, when you buy car insurance, the insurance provider will look at similar factors to decide what the policy costs. What kind of car? How much might repairs cost? Who drives it, and what is their driving history like? Where is it usually parked? We have a whole article on calculating car insurance premiums, if you’re interested in the subject.

There can be hundreds of factors that insurers may consider while determining premiums, which is why you’ll often receive wildly different insurance quotes from different providers. Everyone has their own secret sauce, so to speak, when it comes to calculating premiums.

In the end they’re all trying to accomplish the same thing: offer as many policies as they can while collecting enough premiums to cover all their customers’ claims (without going bankrupt).

Looking for another insurance definition? Look it up in The Insurance Glossary, home to dozens of easy-to-follow definitions for the most common insurance terms. Or, get an online quote in under 5 minutes and find out how affordable personalized home insurance can be.