What Is an Insurance Premium (and How Does It Work)?

Insurance premium explained photo of collecting money in piles
Understanding the insurance premium and how it works. Hero Images / Getty Images

Everyone knows insurance costs money, but a term that is often new when you first start buying insurance is premium. Here are the basics to help you understand what an insurance premium is and how it works.

What Is the Insurance Premium?

In the most simple terms, the insurance premium is defined as the amount of money the insurance company is going to charge you for the insurance policy you are purchasing.

The insurance premium is the cost of your insurance.

Insurance Premiums usually have a base calculation, and then based on your personal information, location and other company determined information, will have discounts that are added to the base premium, in order to get preferred rates, or more competitive or cheaper insurance premiums based on information, which we outline in greater detail in the 4 factors that determine premium listed below. 

The insurance premium is sometimes paid on an annual basis, semi-annual or most companies today, allow monthly financing of the premium. If the insurance company decides they want the insurance premium up front, they may also require that. This is often the case when a person has had their insurance policy canceled for non-payment in the past.

The premium is the basis of your "insurance payment". An insurance premium may then be taxed, or services fees may sometimes be added to it depending on the local insurance laws, and the provider of your contract.

The , or your State Insurance Commissioners office can provide you with more information on your local regulations if you question fees or charges on your premium.

Any charges above and beyond the cost of the policy is not the premium.

Extra charges may be added, for example, when a company charges issuance fees.

The extra fees are not premium, they would normally be defined separately if you looked at your statement of account.

How Much Is an Insurance Premium?

An insurance premium will be more or less expensive and cost can vary depending on the type of coverage you are looking for, as well as the risk.

This is why it is always a good idea to shop for insurance or work with an insurance professional who can shop premiums with several insurance companies for you.

When people shop around for insurance, they may find different premiums charged for the cost of their insurance with different insurance companies and save a lot of money on insurance premiums, just by finding a company that is more interested in "writing the risk". 

What Factors Determine the Premium?

An insurance premium is usually determined by 4 key factors:

1. How the Type of Coverage Affects Insurance Premiums

Insurance companies offer different options when you purchase an insurance policy. The more coverage you get, or the more comprehensive coverage you choose, the higher your insurance premium may be. For example, when looking at premiums for home insurance, if you purchase open perils or all risk coverage home insurance policy, it will be more expensive than a named perils home insurance policy that is only covering the basics.

   

2. How the Amount of Coverage Affects Your Insurance Premium Cost

Whether you are purchasing life insurance, car insurance, health insurance, or any insurance you will always pay more premium (more money) for higher amounts of coverage.

This can work in two ways, the first way is pretty straightforward, the second way is a little more complicated, but a good way to save on your insurance premiums:

  • Your amount of coverage can be altered by the dollar value you want on whatever you are insuring. For example, insuring a house for $250,000 will be different than insuring a house at $500,000. It's pretty straightforward: the more dollar value that you want to insure the more expensive the premium will be
  • You can pay less money for the same amount of coverage if you take a policy with a higher deductible. In the case of health insurance or supplemental health policies, you can not only take higher deductibles, but look at policies with different options like higher co-pays, or longer waiting periods

    3. The Personal Information of the Insurance Policy Applicant

    Your insurance history, where you live, and other factors of your life are used as part of the calculation to determine the insurance premium that will be charged. Every insurance company will use different rating criteria.

    Some companies use insurance scores which can be determined by many personal factors, from credit rating to car accident frequency or personal claims history and even occupation. These factors often translate into discounts on an insurance policy premium.

    For health insurance or life insurance, other risk factors specific to the person being insured will be used as well. 

    Insurance companies have target clients, just like any business. In order to be competitive, insurance companies will determine what the profile of client they want to attract is and create programs or discounts to help attract their target clients. For example, one insurance company may decide they want to attract seniors or retirees as clients, where another will price their premiums to attract young families or millennials.

    4. Competition in the Insurance Industry and Target Area

    If an insurance company decides they want to aggressively pursue a market segment, they may deviate rates to attract new business. This is an interesting facet of insurance premium because it may drastically alter rates on a temporary basis, or more permanent basis if the insurance company is having success and getting good results in the market. 

    Who Decides the Insurance Premium

    Every insurance company has people who work in various areas of risk assessment.

    Actuaries, for example, work for an insurance company to determine:

    • the likelihood of a risk and perils
    • the costs associated with the event of a disaster, or claim and then, actuaries have to create projections and guidelines based on this information

    Using the calculations, actuaries determine how much cost will be involved in paying claims as well as how much money the insurance company should collect in order to make sure that they make enough money to pay potential claims and also make money. 

    The information from the actuaries helps shape underwriting. Underwriters are given guidelines to underwrite the risk, a part of this is determining the premium.

    The insurance company decides how much money they will charge for the insurance contract they are selling you.  

    What Does the Insurance Company Do With Insurance Premiums?

    The insurance company has to collect the premiums from many and make sure they save enough of that money in liquid assets to be able to pay the claims of the few. The insurance company will take your premium and put it aside, letting it grow for every year you don't have a claim. If the insurance company collects more money then what they pay in claim costs, operational costs and other expenses, they will be profitable.

    Why Do Insurance Premiums Go Up and Down?

    In profitable years, an insurance company may not need to increase insurance premiums. In less profitable years, if an insurance company sustains more claims and losses than anticipated then they may have to review their insurance premium structure and re-assess the risk factors in what they are insuring. In cases like this, premiums may go up. 

    Examples of Insurance Premium Adjustments and Rate Increases

    Have you ever spoken to a friend insured with one insurance company and heard them say what great rates they have, then compared it with your own experience with the prices for the same company and had it be completely different? This could happen based on various personal factors, discounts, or location factors, as well competition or loss experience of the insurance company.

    For example, if the insurance company actuaries review a certain area one year and determine it has a low-risk factor and only charge very minimal premiums that year, but then by the end of the year they see a rise in crime, a major disaster, high losses or claims payouts for unforeseen reasons, it may cause them to review their results and change the premium they will charge for that area in the new year.

    That area will then possibly see rate increases as a result. The insurance company has to do this to be able to stay in business. People in that area may then shop around, and go somewhere else. By pricing the premiums in that area higher than before, people may change insurance company. As the insurance company loses the clients in that area who aren't willing to pay the premium they want to charge for what they have determined as the risk, their profitability or loss ratios will likely decrease and this is good for business for the insurance company and the remaining clients they insure, since the cost of claims is spread out over the many clients they have.

    Fewer claims and proper premium charges for the risks will allow the insurance company to maintain reasonable costs for their target client.

    How to Get the Lowest Insurance Premium

    The trick to getting the lowest insurance premium is finding the insurance company that is most interested in insuring you.

    When an insurance company rates go too high all of a sudden, it is always worth asking your representative if there is anything that can be done to reduce the premium.

    If the insurance company is unwilling to change the premium they are charging you, and it doesn't sound reasonable to you, then shopping around may find you a better price if there is another insurance company that is more interested in competing for your business.  Shopping around will also give you a better understanding of the average cost of insurance for your risk.

    Asking your insurance representative or an insurance professional to explain the reasons why your premium increases and if there are any opportunities for getting discounts or reduce insurance premium costs will also help you understand if you are in a position to get a better price and how to do so.