Cost of Insurance Premium

Valid until 31 January 2015 (unless noted)

Cost of Insurance Premium, usually this case is quite technical and complex. On life insurance, cost of premium can be done easily. But on the other types of insurance, for instance: accidents, determining the premium will be more difficult and more complex. In principle, to determine the cost of insurance premium can be done by calculating the estimated loss for a particular risk class plus a profit target, and then calculate the amount of exposure (contract) that obtained, then dividing the expected losses with the amount of the contract. In some situations determining the risk class is easy, while in other situations, determining the risk class is difficult. For example, at the risk of death, in general, risk class determined by using gender (male and female) and age group (1-10 years, 10-20 years, and so on) to estimate the mortality rate in the class. Other characteristics can be added, for instance: employment, smoking or not, health habits, driving record, and other risk. At others risks, such as fire, determining the risk classes is more difficult. Risk class can be made for example: whether there is a fire deterrent or not, geographic location, town or village, and other attributes that are relevant.

Here is a simple illustration to determine insurance premium. Suppose in a region, insurance company will pay the estimated losses due to a car accident which amount reached 100.000 US$ per year. Insurance companies can estimate that they can obtain 1000 contract. Insurance company targets profit is 20 US$ per contract of insurance. Thus the insurance premium can be calculated as follows:

Premium before the target profit = 100.000 / 1000 = 100 US$
Premium (with profit) = 100 + 20 = 120 US$

Thus the insurance company will charge 120 US$ per year to customers.

Another alternative is to reserve the return stated in percentage. For example, insurance companies targeting gross margin of 30% of the premium to cover costs and profit targets. The premium can be calculated as follows:

Premium before the target profit = 100 US$
Margin / spread = 30%

Premium (with profit) = Premium before target profit + (margin x Premium before target profit)
Premium (with profit) = 100 + (0,3 x 100) = 130 US$

Thus the insurance company will charge 130 US$ per year to customers.

In general, the ideal premium rate should be not too high and not too low, fair to all customers, and can be revised, to encourage loss prevention efforts. Determining the premium can be difficult because historical data are often used to estimate the losses in the future. Premium should also be fair to the individual customers; means must consider the customer’s level of risk behavior (moral hazard). High risk moral hazard customers should pay higher insurance premiums. For example, car insurance for teen driver usually charges a higher premium than for adults. Statistics show that teen driver accident rate is higher than adult. So if you want to get a lower insurance premium rates you must also maintain the moral hazard because insurance company will always evaluate customer’s moral hazard.