How is my insurance premium calculated?
An insurance premium is the money charged by insurance companies for coverage. Insurance premiums for services differ from company to company, so it is advisable that individuals shop around for insurance premiums. However, it is important to note that, sometimes, insurance premiums quoted are slightly different from the premiums charged. The difference between the quote and the actual charge can be attributed to the way the insurance premium is calculated. The amount of insurance premiums charged by the insurance companies is determined by statistics and mathematical calculations done by the underwriting department of the insurance company.
The level of insurance premium charged to a customer depends on statistical data that exists about life history, age and health. For example, an 18-year-old man who drives a red sports car is more likely to pay a higher insurance premium than a 50-year-old man who drives a four-door sedan. Every customer that applies for insurance goes through the underwriting process. The underwriting process involves investigation into familial diseases, analysis of reports like medical information bureau and motor vehicle reports. After the information is gathered and analyzed, they are typically analyzed by a statistician, called actuaries, hired by the insurance companies. After analyzing the data, the actuary tries to predict how likely the insurance applicant will make a claim on their policy. The higher the probability of a claim, the higher the premiums usually are.
The actuaries are also responsible for studying mathematical data and compiling "mortality and sickness" tables, which are used to predict prospective losses due to death and sicknesses. The mortality and sickness tables are basically tables that assign probability to gender and ages about the likelihood to get sick or die. The actuaries use these tables to develop models that determine how likely it is for a particular individual to get sick or die at a particular time, based on the data gathered for that individual. Based on the results of the analysis of data and the information generated from the mortality and sickness tables, a premium is assigned or charges to the client. (To learn more about the industry, check out The Industry Handbook: The Insurance Industry)
I've been selling life insurance for 25 years, and am still amazed at the genius behind setting pricing. There's an entire industry of underwriters, actuaries, and business managers who collectively set premiums. These people actually use a systematic method of determining your probable mortality, factor in standard business costs, and at the same time, consider potential investment returns so that the carrier can still make money while obligating itself to pay your beneficiaries within a week or so of a claim being filed. The net result has been trillions of dollars pouring into the economy through claims being paid over decades, and many hundreds of companies flourishing in the process. For me, this is quite a success story.
And don't forget that mortality itself is a very sophisticated topic. Virtually every part of life affects mortality, and these people have to consider it all. Underwriting considers current health, medical history, family medical history, vocation, avocation, lifestyle, and financial/criminal/motor vehicle record. I think that life insurance by far is the most exhaustive qualifying process for any purchase, certainly in the financial world.
What a great question for Investopedia!
Lets assume you are talking about premium pricing for, say, a 20 year level premium term life insurance. The company's goal is to make money on the insurance policy and avoid unanticipated losses. Insurance companies employed highly educated and experienced actuaries to try and predict what their future claims experience will be.
So what drives the premium calculation? Gender, age, vocation, recreation (risk-related such as skydiving or rock climbing), family mortality experience, and a host of personal health data factors are run through the actuarial model to create a profitable pricing structure. Ideally for the insurance company, every insured person would outlive the term or simply let their policy lapse prior to any claim. I hope that helps. Good luck!