What am I paying for in an insurance premium?Easy

Four things, and only one of them is your own expected loss. The rest is the cost of running the promise, the cost of the capital behind it, and the insurer's margin.

4 min read · 739 words

The short answer: a premium is not a price for a thing, it is a price for a promise, and it has four parts. The expected cost of your claims is one of them. The others are the cost of running the business, the cost of holding capital against the possibility that claims are far worse than expected, and the margin the insurer intends to make.

The four parts

• Expected loss. What claims from a group like yours are expected to cost, per policy, over the period. This is a statistical statement about the group, never a prediction about you.
• Expenses. Selling the policy, administering it, investigating and paying claims. Fixed costs spread over policies, which is why very small policies carry proportionally more of them.
• The cost of capital. The insurer has to hold money against the year in which claims come in far above expectation. That capital has an owner who wants a return on it, and that return is charged into every premium.
• Margin. What is left if the year goes as assumed.

Underwriting is the seat that decides the first part and prices the rest around it.

Why the third part is bigger than people expect

If claims were smooth, an insurer would need very little capital and premiums would be close to expected loss plus expenses. They are not smooth. Some risks are close to independent — one person's car accident says nothing about the next person's — and those average out beautifully as the book grows. Others are correlated: a storm damages ten thousand roofs on the same afternoon, and averaging does nothing at all.

An insurer's capital is sized against the correlated case, so a risk whose bad outcomes arrive together costs far more to carry than one whose bad outcomes arrive one at a time. That is the whole reason diversification matters here in a way it does not in a supermarket, and why the most concentrated risks get passed on again — reinsurance, and beyond that a catastrophe bond that hands the exposure to investors outright.

The money in between

Premiums arrive before claims are paid, and for some kinds of insurance the gap is years. In the meantime the money is invested. That pool is the float, and the return on it is a real part of the economics: an insurer can accept a lower margin on the underwriting if the float earns.

What the float can be invested in is not a free choice. It has to be there when claims are, so its shape is decided by the shape of the liabilities. Insurance investment is the seat that runs it, and it is one of the largest sources of demand for long-dated bonds in the market — again on the forced side rather than the choosing side.

Why two people pay different premiums for the same cover

Because they have been sorted into different groups. Rating factors are the observable things that correlate with claim frequency or severity, and the whole exercise is putting a policy into the narrowest group the insurer can justify and price.

Two consequences follow, and both are structural rather than accidental. Better sorting means more people paying something closer to their own expected cost, which is fairer in one sense and removes the cross-subsidy in another. And the person who knows most about their own risk is the person buying the policy, which is why insurers ask questions, why answers matter contractually, and why some cover is compulsory or pooled by statute rather than sold.

When the policy is also an investment

Some contracts are protection and savings in one wrapper, and then the premium is doing two jobs. A unit-linked policy puts part of the premium into funds and part into the cost of the cover, and the two are not always presented separately. What the wrapper changes is the page on what a wrapper does and does not do to what is inside it.

This page describes how a premium is built. It is not advice about any policy, and nothing here says whether a particular cover is worth buying.

The one sentence to take away

You are paying for your expected claims plus the cost of somebody holding enough capital to still be there in the bad year — and it is the second part, not the first, that explains why correlated risks are so much dearer to insure.