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What is an Insurance Premium?

What is an Insurance Premium?

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Matthew Collister
Updated February 10, 2022
5 Min Read

An insurance premium, in its simplest definition, is the amount of money you pay for an insurance policy. In return for paying this premium, you can expect your insurance company to pay for any claims you have, based on the terms of your policy. 

How insurance premiums work

An insurance policy is a contract between you and an insurance company. Whether it’s for your car, home, health, or life, the policy contract explains the conditions under which the insurance company will pay if you have a claim. Your part of this contract involves the on-time payment of your premium. You can think of your insurance premium as the price you pay to be insured.

So when you buy an insurance policy, the insurance company will tell you how much you owe — your premium. Depending on the policy type and the insurer, you may have to pay the premium annually, semi-annually, or monthly. Once the insurer receives your premium, your policy is in effect. If you miss a payment, the insurance company may cancel the policy and no longer pay if you have a claim.

How insurance premiums are calculated — the science

Think about a manufacturer of televisions. It knows its exact costs for parts sourcing, assembly, packaging, shipping, and marketing its products. It can add up these costs, along with a little extra for profit, and charge you appropriately when you buy a new television at an electronics store or online. 

What you pay for that television thus reflects the manufacturer’s known, exact costs. This is true for most of the things you buy.

It’s not true for insurance, however. 

An insurer’s exact costs aren’t known until after you buy their product. That’s because those costs will be based partly on whether or not you have to file a claim and how severe that claim is. Neither of these things is known when you buy your policy.  

An insurer, therefore, must predict your likelihood of filing a claim. Such predictions are made using sophisticated algorithms and data such as your age, where you live, and whether you’ve filed claims in the past. These predictions are then used to help calculate what you pay as premium. This science is the foundation of insurance.

Other factors that affect your insurance premium

Several other factors may affect your premium, including:

  • The amount of coverage you buy
  • If applicable, your choices for limits and deductibles
  • Whether you buy optional coverages
  • Any discounts provided by the insurance company

Your insurance premium will also reflect the insurance company’s overall cost of doing business: Think of traditional overhead costs such as employee salaries, equipment, utilities, facilities, and taxes.

Why your insurance premium may change

Be aware that the insurance company may raise or lower your premium. These adjustments can occur because your claims activity is costlier than the insurance company's prediction or simply because the company's overall cost of doing business has changed. A large number of unexpected claims (for instance, a rash of home damage claims due to an unusually active storm season) can also cause an insurance company to raise premiums.

An insurer may also adjust premiums based on market forces and its competitive situation. For example, a company may lower its premiums to attract more customers or raise premiums to help it manage its growth rate. 

For policies with an annual term (such as a car or homeowners insurance policy), you’ll usually be notified of a premium change when it’s time for renewal. 

Types of premiums and factors that affect them

Let's look at some factors that affect insurance premiums for different types of policies.

Car insurance premiums

Insurers evaluate factors such as your age; the year, make, and model of your car; your driving record and claims history; and the address where you keep the car. Many insurers also look at your credit history — your use of credit has been found to be an accurate predictor of the likelihood you’ll file a claim (people with more responsible credit use tend to file fewer claims). 

Mature drivers with clean driving records and good credit, living in areas with fewer car accidents, can expect to pay less in premium for car insurance. 

Life insurance premiums

Insurers will evaluate your age and your medical history. For most policies, they’ll also require you to take a medical exam. This could be as simple as a questionnaire over the phone or an in-person exam with bloodwork completed by a lab. 

Generally, the younger and healthier you are, the less you can expect to pay for a life insurance policy. 

Renters insurance premiums

Insurers assess the value of your belongings, the location of the building (including proximity to a fire department and the crime rate of the area), and the presence of a burglar alarm.

People with higher value belongings can expect to pay more for insurance, but this can be offset depending on the factors listed above.

Homeowners insurance premiums

Insurers evaluate your home's location, value, and age; your credit score; and your claims history. They may also consider the presence of a burglar alarm, working smoke detectors, and your home’s proximity to a fire department.

Health insurance premiums

If your policy is purchased through the federal government's health insurance exchange (either by you or your employer), insurers can evaluate only five factors to determine the premium. These are age, where you live, tobacco use, whether the policy covers just an individual or includes other family members, and category of insurance plan. 

These rules do not apply to group health plans for larger employers who purchase insurance coverage outside the exchange. However, under no circumstances will your medical history, health, or gender be used to calculate your fully insured premium. Further, all health plans cover the same essential health benefits and must cover treatment for pre-existing conditions from the day coverage starts.

 Note that if you have group health insurance as a benefit from your employer and your employer purchases coverage from an insurance company, the employer typically pays the premium directly to the insurance company. It then deducts part of all of that cost from your paycheck (employers with more generous health insurance benefits pay for a larger share). If you buy insurance as an individual, you pay the premium directly to the insurance company.

Frequently asked questions

What’s the difference between an insurance premium and an insurance rate?

The terms “premium” and “rate” are often used interchangeably to describe what you pay for an insurance policy. But they do mean slightly different things. 

The rate is the actual cost to insure you, as determined by the insurer’s rating algorithms. It’s a reflection of the likelihood you’ll file a claim. 

The premium is the rate with any discounts or surcharges factored in. This, therefore, represents exactly what you pay for the policy.

Why did my insurance premium go up when I didn’t have a claim?

Insurance premiums can be affected by many factors unrelated to whether you have a claim. If the insurer’s cost of doing business increases, or it has an unexpectedly large number of clams, you might expect your premium to go up.

How can I lower my insurance premium?

One of the smartest things you can do is to shop around, as insurance premiums can vary significantly between companies. You should also evaluate your policies to make sure your limits, deductibles, and coverage selections all match your needs. You may find, for instance, that you have coverages you no longer need. An insurance agent can help you evaluate your needs and match you with a policy that fits your budget.

Why did my car insurance premium go up after an address change?

Insurance companies look at a wide variety of information when calculating your car insurance premium. This includes your address. If you've moved to an area with a greater incidence of car theft or accidents, you might experience a premium increase.