Ever wonder how a St. Louis insurance company decides how much to charge its customers in exchange for insurance coverage? Learn how they go about calculating insurance premiums.

## The Many Factors Of Calculating Insurance Premiums

A multitude of factors are weighed when an insurer decides whether or not to grant coverage to a potential customer. Even more factors are considered when deciding how much to charge in premiums if coverage is to be granted.

Insurance companies provide essential services to the public, but they are first and foremost in business to make a profit. In addition, state regulations require insurers to maintain certain levels of financial security in order to legally operate. Since premiums represent the primary stream of revenue for insurance providers, they must ensure that these revenues exceed their expenses.

Insurers are able to do this by examining several key ratios. The first is the loss ratio, which is the percentage of losses experienced by an insurance provider measured against the money received in premiums. Another is the expense ratio, which measures the costs of doing business (such as those associated with establishing and maintaining insurance policies, including employee salaries and other overhead expenses) against earned premiums.

Finally, the combined ratio, as the name might suggest, is the sum of both the loss and expense ratios. A combined ratio of less than 100% indicates a profit, while a ratio over 100% represents a loss.

## The following example illustrates how an insurer uses these ratios to determine its yearly profitability:

ABC Insurance earned \$20 million from premiums last year. Its operating costs were \$8 million, and it also paid out \$10 million in claims over the previous year.

\$10 million in claims / \$20 million in premiums = .5 or 50%, which is the loss ratio.

\$8 million in operating expenses / \$20 million in premiums = .4 or 40%, which is the combined ratio.

50% + 40% = 90%, which is ABC’s final combined ratio. Since it is less than 100%, ABC Insurance earned a profit last year.

So how do insurers know how much to charge in individual premiums in order to ensure that they earn enough to exceed the costs of claims and overhead? This entails careful examination of several more factors.

First, the insurer must weigh the level of risk posed by insuring a potential customer. This is accomplished by measuring risk factors based on its prior experience. Three common methods are often used to measure risk and calculate the appropriate premium for coverage – the judgment, manual, and merit ratings.

The judgment rating is the oldest rating method used to determine premiums, and is not as often used as the other two. The judgment rating is employed by an underwriter individually evaluating each risk, and using her best judgment to calculate a premium amount. No predetermined risk tables or manuals are consulted to establish the premium.

### Manual Ratings – Calculating Insurance Premiums

Meanwhile, the manual rating (also known as a class rating) requires the underwriter to consult a manual containing predetermined rates for each category of risk for a specific local area.

The merit rating further modifies the manual rating to more accurately fit the unique characteristics of the risk to be covered. For example, a series of discounts can be applied to customers who pose less of a risk to the insurer, thus decreasing the amount that the insurer will likely have to pay in claims. With health insurance, this might mean charging lower premiums for non-smokers versus those charged to smokers, while property owners might receive a merit rating discount for installing a sprinkler system, thus reducing the risk of fire damage.

In most cases, a greater level of risk results in higher premiums. An insurer settles on an amount where the amount earned from a customer is likely to exceed the amount it will have to pay in claims; this is known as the net single premium. At this point, the insurer attaches an expense load to the net single premium to cover the costs of doing business; this includes such factors as producer commissions, overhead expenses, and obligations to pay the immediate claims of other customers.

The net single premium is combined with the expense load to create the gross annual premium. This is the amount that the customer pays for his policy.

However, premium amounts are also subject to state and federal consumer protection laws. Which vary depending on the area in which the customer resides. A great example is the requirements enacted by the Patient Protection and Affordable Care Act (PPACA). It requires health insurers to limit their expense loads to specific amounts. Those who want to know more about these consumer protection laws should consult the PPACA, and their state insurance departments.

Missouri, by the way, is file and use.