Insurance Premium Defined, How It's Calculated, and Types

What Is an Insurance Premium?

An insurance premium is the amount of money an individual or business pays for an insurance policy. Insurance premiums are paid on policies that cover a variety of personal and commercial risks. If the policyowner fails to pay the premium, the insurance company may cancel the policy.

How an Insurance Premium Works

When you sign up for an insurance policy, your insurer will charge you a premium. This is the amount you pay to keep the policy in force. 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.

The price of the premium depends on a variety of factors, including:

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

Insurance companies make money by collecting premiums and by investing this revenue in safe financial instruments, such as bonds. Once the insurance company earns the premium by providing protection, it becomes income for the carrier. Unearned premiums also represent a liability, as the insurer must provide coverage for claims being made against the policy.

How Premiums Are Calculated

Insurance companies consider a variety of factors to decide how much premium they will charge a given policyowner for a given set of coverages. While some of those factors are common across most types of insurance (such as the age of the insured), others vary depending on the type of coverage,

Auto Insurance

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.

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.

Life Insurance

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. 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.

Health Insurance

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.

The Process of Setting Premiums

Insurance companies employ actuaries to determine risk levels and premium prices for a given insurance policy and for groups of policies. While the emergence of sophisticated algorithms and artificial intelligence is changing how insurance is priced and sold, human actuaries are still key to the process. 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.

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.

Finding the Best Price

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.

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.