Insurance; It’s a Gamble

Did you ever wonder how an insurance company comes up with the rates they charge? Often times it’s hard to imagine that there could be any true basis for the rates. If you’re like most people, you probably have a strong gut feeling that the insurance company is pulling the rate they charge magically out of a hat, or more simply, based on how much they can rip you off.


The reality is that there is a real science involved in how base insurance rates, for each type of coverage, are calculated and then customized to you. Like gambling, insurance deals with odds and statistics. Companies look at how many homes in the United States will experience a fire in a given year compared to all homes in the US. Their statistics study the frequency of a total loss fire as well as a small chimney fire. They add to the fire rating factor, the frequency and severity of many other types or classifications of losses. As an example, rates for a homeowner’s policy consider the potential for a home to be damaged by a fire, hurricane, windstorm, freezing pipes, robbery, and likely about a hundred other exposures.


There are adjustments made for regions having a higher frequency of hurricanes, tornadoes, ice and hail storms, brush fires… They look at the ratio of homes damaged by any one of these exposures and calculate the average cost to repair or replace the property after such a loss. When they have these individual exposure statistics, the insurers make a collective projection of the odds that your home will have a loss of any type during the policy year. They then prepare projections of how many homes out of every 100 insured will experience a loss. When playing Power Ball, chances are you won’t hit the one winning number but there are a lot of one, two, three and four ball matches.  The same laws of large numbers apply to insurance.


Those numbers enable insurance companies to project what is known as a “Loss Cost Factor”. That is the average cost of all losses spread amongst all of a company’s insured clients. Insurance companies use those statistics to justify the rates they are currently charging, or proposing, when they seek rate approval from each of the respective states where they do business.  Commonly about 55 cents of every homeowner insurance premium dollar is included in your rate to cover the expected Lost Cost Factor.


When going before the state regulators, they want to know both short term and long term trends. The rapid rise in dog bite settlements would be a short term trend while the average of 1 hurricane hitting RI every 10 years would be a long term trend. The companies have to justify to the regulators the respective cost allocations for each of these potentials.


There’s a big if that can’t be forgotten in projecting those loss costs; what happens when “Mother Nature” deviates from her predictable weather scenarios. Locally we’ve recently seen examples of such anomalies. There was the 2012 October snow storm that left homes in western RI without power for 3-5 days. There was a Tornado that stretched across western Massachusetts two years ago leaving several hundred million dollars in damage. Then who from Rhode Island could forget the extreme flooding we experienced in 2010. These were factors not seen in the 50 or 100 year weather histories; thus not included in the loss cost projections. Those losses serve to prove that despite the best statistics, insurance is still a gamble.


While these base rates are established for each coverage type, there are individual things that customize the respective rate to you. Examples include the age of your home and when the roof, electric, plumbing and heating systems were updated or replaced. A home built or revitalized within the last 20 years is much less likely to have a loss than a home with no updates in more than 20 years. Because the data collected proves this, insurance companies offer discounts to reflect those improvements.  The presence of a fire and burglar alarm system usually results in rating discounts. The companies recognize that with early detection, the police and fire departments are likely to respond sooner thus minimizing the loss.


Local factors can negatively impact on your rates as well. The Fire Protection Classification for most of Scituate, Foster, and Glocester is near the highest at a 9 on a 10 point scale. With most insurance companies, that translates to higher costs for our insurance. But you can save money by finding an insurance company offering “Suburban Rating”. This discount recognizes that unlike most “PC9” towns, our fire departments do have well trained volunteers, late model tank trucks to shuttle the water when needed, along with ample supplies of water through the reservoir, ponds, and lakes.


The costs most insurance companies fight hardest to control are their administrative costs. These are the costs associated with:  the Actuaries  who determine the rates that are necessary; the attorneys and legal services teams who deal with the wording of policies, claims settlements, and interact with the varied state insurance departments; the Underwriting staff  who customize your policy to meet your needs; the Claims investigators who work to pay legitimate claims and to fight the fraudulent ones; and the Information Technology staff who are critical to an insurance company considering the extreme reliance on computers. Each position adds to the bottom line administrative costs for an insurance company. The result is an administrative cost factor totaling an average of 35-40 cents of every premium dollar.


If you total up the .55 for expected losses and .35-.40 for administrative expenses, there is .05-.10 from every premium dollar to be absorbed by unexpected losses, taxes, and the profit margins sought by the company stock holders. Reality is that mere pennies on every premium dollar determine the profitability of an insurance company.