Insurance Planning: Part II
Premiums
Premiums are the payments that you make to your insurance provider, so it's key that you understand what they are and how they work.
What are premiums?
In exchange for insurance protection, policyholders make periodic payments called "premiums" to their insurance provider. Paying these premiums enables the policyholder to receive a cash payout or service in case of need. Completing the loop, the insurance company invests the premiums it collects in stocks, bonds, and real estate. The proceeds from these investments serve as an important source of revenue for the insurance company. The difference between the money paid out to cover losses and the returns on their investments is how insurance companies make their money.
How are premiums set?
There are several factors that contribute to the price of your premiums. These include:
Risk: How high risk a client are you? Rule : The higher the probability that you will file a claim, the higher your premiums will be.
Liability:
The potential payout that the insurance company is exposed to will also affect your premiums. Does your home contain many valuables? Is your car an expensive one? Is it new? If the answer to these kinds of questions is yes, then you'll have higher premiums.
Rule : The larger the potential loss, the larger the premiums will be.
Deductibles:
What percentage of the loss are you responsible for? Sometimes, as with life insurance, insurance companies are required to cover the entire loss. In other cases though, policies may have deductibles. A deductible is the amount you pay for a covered loss before the insurance company begins picking up the bill. Rule: The higher your deductible, the lower your premiums will be.
Experience:
What is the insurance provider's track record? Not all insurance providers were created equal. The company's level of administrative and marketing expenses as well as its investment expertise and pay out history will impact your premiums. Rule: The better the company's track record, generally the more reasonable your premiums will be.
Tip: Be wary of premiums that seem too good to be true. There may be a short term benefit, but you may incur long term problems relating to renewability, premium guarantees and the like. The actuarial numbers (risk of loss) that form the basis for premium development are normally quite similar. So something has to give in the "assumptions" (under which circumstances benefits will be paid) if premiums are dramatically different. You need to be comparing apples to apples, or, in this case, comparable contractual provisions.
Competition:
How many other insurance companies offer similar plans? The competition in the line of insurance you're purchasing will have an effect on your premiums. Think simple supply and demand -- if only a few insurance companies are willing to take a certain type of risk, then they can charge higher premiums.
Rule : The more competition, the lower your premiums will be.
Given the factors above, there are no set formulas in the pricing of insurance policies. Extensive comparison shopping will reveal various premium levels across companies.
Continue to: Part III Insurance ratings
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