Why Does Insurance Cost So Much? Q & A On Insurance Charges

by Kosmo on 2011-07-036

Do you ever wonder about why insurance coverage costs the way it does? As consumers, we’re often frustrated about why our policies are priced the way they are and spend a tremendous amount of time shopping around for cheap insurance. Well, allow me to answer some of those burning questions on how insurance companies set their prices. Understanding how costs are calculated may help put things in perspective.

Q & A On Insurance Charges: Setting The Price of Coverage

#1 I’m young, but I’m a good driver. Why is my car insurance so expensive?
Insurance is the business of predicting future events and sharing the risk of those events across a large pool of people. Insurance companies know that some drivers will have accidents each year, but there is no way to predict exactly who those drivers are. If an insurance company knew that Gordon Jeffries of Lincoln, Nebraska was going to run a semi loaded with Faberge eggs of the road and into the Grand Canyon, they certainly wouldn’t insure Gordon.

But there’s no way to determine that Gordon –- or any other driver -– will have an accident. If insurance companies simply wait for Gordon Jeffries to have his accident, it’s too late –- even high-risk insurance isn’t going to cover the cost of those Faberge eggs.

What the insurance companies can do is use historical data to determine the likelihood that a person will be involved in an accident. Statistical data shows that a 19 year old driver is far more likely to be in an accident than a 32 year old driver, and that males are more likely to be in an accident than females. It’s quite possible that your 32 year old sister (who is paying a low rate) will have an accident this year and your 19 year old brother (paying a fair higher rate) is the most careful driver in the world. However, as a whole, the entire population of 32 year old females will be involved in far fewer accidents (per mile driven) than the 19 year old males. (The best thing about being in the young driver group is that you know you’ll eventually get out of the group).

It’s in the best interest of an insurance company to charge rates that accurately reflect the risk. If they overcharge for lower risks, another company will undercut them on price. If they undercharge for higher risks, they’ll pay more in claims than they charge in premiums. Both situations are undesirable.

#2 What’s the point of an insurance deductible?
A deductible is a way of sharing risk with the insured person (generally referred to simply as “the insured”). If the insured knows that he is responsible for the first $100, $250, $500, or $1,000, he may be a bit more careful. Perhaps Gordon Jeffries pays more attention, stays in his lane, and avoids running that semi off the road — saving the insurance company a huge payout.

There is a second reason for deductibles: they avoid small claims. Do you think it costs the company more to pay a single $1,050 claim or ten claims of $100 each? The ten claims of $100 each are going to cost the company more. Why? Overhead. There’s a certain amount of fixed overhead in the claim handling process, making smaller claims more costly than it would appear.

#3 Why does liability coverage decrease in price?
If you shop around, you’ll find that the premium for $1,000,000 of liability coverage will not cost forty times as much as $25,000 of coverage. Why are the rates not linear? A smart part of this is related to overhead –- it costs roughly the same amount of money to issue either policy. However, the bigger factor is that it’s far less likely that you’ll ever have a claim where the $1,000,000 limit comes into play –- but having a $25,000 is relatively common. As the risks decrease at each level, so does the cost.

#4 How does my new insurance company know about claims I made with my old company?
The insurance industry uses a database called the Comprehensive Loss Underwriting Exchange (CLUE) to maintain a history of claims and damage reports. The CLUE database makes it possible for an insurance company to determine if you have a high likelihood of making a claim so that the company may set rates accordingly.

The CLUE database also allows insurance companies to flag certain claims as potentially fraudulent. For example, there are some fraudsters who perpetuate “slip-and-fall” fraud on business owners. Not every slip-and-fall claim is fraudulent, as anyone can slip on a grape in a grocery store and break his hip. However, if the CLUE database shows that you’ve had five slip-and-fall incidents in the past three years, they may choose to investigate the claim more carefully. Fraud is a serious problem in the insurance industry, costing companies (and indirectly, customers) billions of dollars every year.

#5 What can you do when you’re not happy about your insurance company?
If you’re unhappy about your insurance company, there are a few things you can do. Of course, you can always vote with your feet and your wallet. You can take your business elsewhere. But there’s another approach that many consumers are not aware of. Being a policy holder can influence change within corporate management, in some cases. In the case of mutual insurance companies, such a company is owned by the policyholders, which is analogous to a stock company which is owned by shareholders.

In a mutual company, the policyholders actually elect the company’s board of directors at the company’s annual meeting! In practice, the existing board members (or people recommended by senior management) are generally elected. However, it is possible for activists to garner enough support to wage a “proxy fight” wherein they urge policyholders to support a different slate of board members. If you are insured by a mutual company, you’ll receive information about the annual meeting in the mail. If you’re interested, show up at the meeting some year!

That’s our Q & A for now. For more information on how policies are priced (life insurance, in particular), check out this article on paying for life insurance.

Kosmo has been employed in the insurance industry since 1997. In his spare time, he runs The Soap Boxers. He is also the author of Mountains, Meadows, and Chasms, a collection of short stories.

Created June 29, 2008. Updated July 3, 2011. Copyright © 2011 The Digerati Life. All Rights Reserved.

{ 6 comments… read them below or add one }

JD July 3, 2011 at 9:37 am

Good Information that I can use. Thanks.

sam jones July 4, 2011 at 6:27 am

Number 5 about being a policy holder is an interesting concept and I have never heard of it before. Maybe this will be used by groups of policy holders in the future.

SB(One Cent At A Time) July 4, 2011 at 2:35 pm

Lots of insider information that can help people like me. I just got a new car added to my auto insurance and the monthly cost increased by 40%. I will research and write about the reasons behind it.

Kosmo @ The Soap Boxers July 4, 2011 at 7:14 pm

@ Sam – A lot of insurance companies are stock companies, but if you keep you eyes peeled, you’ll see references to mutual companies. Also, it’s not exactly easy to mount a proxy fight. Some mutual companies have millions of policy holders. Trying to get a plurality of these people on your side would cost millions of dollars. But it DOES occassionally happen.

SB – The answer should lie on your update “dec pag” (declarations page). This will list the coverages and costs for each insured vehicle. If you previous had fairly old cars on the policy, it may just be the higher cost of collision and comprehensive coverage for the newer vehicle. If you have a 30 year old “beater”, for example, those coverages are pretty cheap – because the most you’re going to get is fair market value (less your deductible). If the estimate of the repair exceed the value, it’s going to be totaled.

The type of vehicle will have an impact, too. A Lamborghini costs more to repair than a Civic, for example.

Squeaky July 5, 2011 at 5:41 am

Great summary Kosmo. There is definitely a big need to protect themselves from the fraudulent slip and falls, staged rear end accidents, etc. Insurance is a great concept utilizing the law of large numbers and risk pools. It’s too bad there are always people that have to try and take advantage of the system by staging injuries, etc.

Hybrids are a big impact on repair costs too. There are a lot of extra steps that have to be taken with before the normal repairs can begin. Before buying a hybrid, have your insurance company provide a quote for what the cost will be.

I’d love to read something from you that talks about homeowner’s insurance, renter’s insurance, PLUPs, PAP’s, etc. I think we could all benefit from that.

Mike August 3, 2011 at 4:45 am

I always say, the more expensive the insurance, the more you probably need it. (You still need to shop and get the best price though) Insurance companies rate policies on the probability of you having a claim and then by the size of the expected claim. I think it is funny that people will scramble to insure their $1,000 new television but won’t think twice about insuring their own income with disability insurance. The value of their income over their lifetime could be in the millions!

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