Pricing in insurance

You’ve probably wondered how insurance pricing works. How does an insurer put a price on a given risk? Understanding the method used to determine insurance premiums can help you better understand your insurance bill—and even save money.

How is the price determined?

First of all, the people who set pricing on a daily basis for an insurance company are called underwriters. They typically work with rate tables calculated by actuaries. Actuaries compile and analyze claims history to determine the probability of certain events occurring. For example, it might be determined that one out of every 1,000 homes in a neighborhood catches fire each year. That means there’s roughly a one-in-1,000 chance your house could burn down this year. A rate is then established based on that probability, which is used to calculate an insurance premium. The actuaries’ role is to calculate these base rates, which underwriters then use to determine pricing. Underwriters use their judgment to assess the nature of the risk and apply surcharges or discounts to the insurer’s base rate, ultimately setting a premium for each specific risk.

The premium is determined by a rate per $100 of insured value. The type of construction often has a major impact on the rate. A concrete building with sprinklers will be much more favorably priced than a wooden structure, because the risk of fire is significantly lower. This is something to keep in mind when shopping for a new location—insuring property in a wood-frame building will always be more expensive. Having protection systems, a good claims history, or a newer building can earn you additional credits on the insurer’s base rate and help you save money.

Example of Insurance Pricing

For liability insurance, the pricing method is obviously different, since the coverage does not apply to a tangible asset, but rather to damages caused to others. For a business, the more goods it produces or the more work it performs, the greater the likelihood it could cause harm to others. The premium is therefore calculated based on a rate per $1,000 of revenue. When the risk varies significantly depending on revenue, the premium may be subject to annual adjustment. Since it’s difficult to accurately predict a company’s future revenue, a provisional premium is calculated initially, with an adjustment made at the end of the year. Let’s see an example:

• A company forecasts a revenue of $5,000,000 for the 2021–2022 year. Its liability insurance rate is $5 per $1,000 of revenue.
• ($5,000,000 × $5) / $1,000 = $25,000
• At the end of the year, the company actually made only $4,449,333 in revenue. It will therefore be entitled to a credit:
  ($4,449,333 × $5) / $1,000 = $22,246.66
• The year-end credit is thus:
  $25,000 – $22,246.66 = $2,753.34

The company can therefore pay a premium that truly reflects its level of risk. If it has a bad year financially, it may benefit from a credit if its liability insurance is based on an adjustable premium. Most entrepreneurs in the construction industry have insurance policies with this kind of adjustment mechanism. It’s also worth noting that insurance products are subject to a different tax rate: A 9% tax applies to all types of property and casualty insurance.

Key Takeaways on Insurance Pricing

In conclusion, gaining a better understanding of how insurance pricing is structured can help you save on premiums by making the right decisions to minimize your risk.