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Insurance Rate Methods
By Joseph Kenny
The price of depends ultimately on the risk the insurer is taking on on behalf of the customer. Simply put, this will depend on the chance of the insured event occurring, and the likely cost of the outcome. The way insurers calculate this risk, and quantify the amount of the premium, is through the use of what is known as actuarial science. Using certain probability and statistical mathematical models, the company can predict with a fair degree of accuracy, the approximate cost of future claims.
For example, supposing a someone wishes to insure their $100,000 home against fire. For argument’s sake, lets assume that 1 in a 1000 homes in this area burn down every year. This would mean that just to break even, on the mathematical model, the company would have to charge $100 a year for the premium. What the company will in fact do is charge something more than $100, say $120. This extra $20 will cover the overhead costs of the company’s operation. It will also cover an amount for profit of the company. The only other way the company generates profits is by investing all the policy premiums it is paid. That way, all the premiums earn interest, or investment returns, while they are in the possession of the company. While this method represents
a significant income for the company, the majority of company’s funds do actually come from the payment of premiums.
It has been argued that those who pay premiums and do not have to make a claim lose out by effectively wasting their unused premium. In this sense, the industry can not be held to produce any net gain for society, and therefore, the huge profits they generate are unwarranted. Defenders of companies however claim that the peace of mind they offer to all their customers is a significant societal benefit which they provide. Simply knowing that you will be compensated if disaster strikes you is worth something to people, even if the disaster never strikes.
The funds the company holds, from premiums that have not been claimed for payouts, is called its float. Massive profits can be generated from the float alone. While losses are just as possible as gains with all investments, the profits made from company floats, for the five years ending 2003, was $68.4 billion. In the same period, companies paid out $142.3 billion in claims. Some do not believe that the industry will be able to sustain itself for ever on profits generated by the float and so predict large premium rises for the future.
Joseph Kenny is the webmaster of the insurance site www.insure121.com/ where you will find information, news and links to the leading providers of car insurance in the UK.
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