UNDERSTANDING INSURANCE PREMIUMS
BERNARD AKYIN-ARKOH, CPCU, ARM, ACII, EMBA
2nd Runner-Up, AIO-YIPs 2024 NextGen Awards ||2024 Young Achiever Award Winner @ Ghana Insurance Awards||Chartered Insurance Practitioner (CII-UK) || Author || Insurance & Risk Management Consultant||
INTRODUCTION
Have you ever pondered the following inquiries?
1. What is an insurance premium?
2. How are insurance premiums calculated?
3. What factors influence my insurance premium?
4. How do insurance firms manage to cover insurance claims using the relatively small premiums gathered from policyholders?
This article offers an insights into insurance premiums, addressing common questions and providing valuable understanding on the topic.
Insurance serves as a crucial tool for managing risks, offering financial security to individuals and businesses alike. Central to any insurance arrangement lies the notion of insurance premiums, which represent the periodic payments made by policyholders to insurers in return for protection against potential risks.
These premiums constitute the cornerstone of insurance contracts, underscoring their vital importance for both policyholders and insurers. Acquiring a deeper understanding of insurance premiums is paramount, as it equips individuals and businesses with the knowledge needed to make informed decisions regarding their insurance coverage.
WHAT IS AN INSURANCE PREMIUM?
An insurance premium signifies the predetermined payment made by the policyholder to secure insurance coverage. By adhering to the schedule of payments, the policyholder guarantees access to financial protection against any potential losses or damages. The frequency of premium payments—whether monthly, semi-annually, or annually—varies based on the specific insurance policy in force. For instance, life insurance premiums are typically paid monthly, while general insurance policies often require annual payments. Nevertheless, some insurance providers offer flexible payment options, allowing premiums to be paid on a monthly or quarterly basis as per the policy terms.
Policyholders must fulfil regular premium obligations to maintain the active status of their policies. Non-payment could result in the policy being voided, impacting the policyholder's ability to obtain future coverage.
HOW DOES INSURANCE PREMIUM WORK?
With the exception of life insurance where withdrawals are possible, each premium payment typically represents a sunk cost for the sake of peace of mind. In this scenario, the ideal outcome is an accident-free existence, benefiting both the insured individual and the insurance company.
Insurance providers collect premiums from policyholders, pooling them into a collective fund used to cover the losses of a minority facing calamities. Essentially, the premiums paid by individuals without claims contribute to compensating those who do. To explain further, Thousands of insurance customers each contribute a small amount of money to a pool. These contributions are premiums. In exchange for these contributions, they can receive money from the pool when they make a claim. Most people won’t ever need to take money from the pool in a given year, but it’s there if they do need it. This concept is known as risk sharing, and it’s the basic mechanism by which insurance works.
Insurance companies utilise the premiums they gather to maintain sufficient liquid assets, ensuring they can meet their obligations to policyholders in case of claims. Any surplus remaining after covering claims and operational expenses is considered profit, termed earned premium.
FACTORS INFLUENCING INSURANCE PREMIUMS
Insurance premiums are influenced by a multitude of factors, ranging from the characteristics of the policyholder to the nature of the property to be insured, as well as broader economic conditions and other relevant considerations. Policyholders understanding of these factors will assist them in managing its risk exposure to attract favourable premiums from their insurers. The following are some of the major factors that influences insurance premiums for both life and general insurance policies.
1. Risk Profile of the Insured or Policyholder: The determination of insurance premiums for various types of insurance policies including life insurance policies heavily relies on assessing the risk profile of the policyholder or any related parties. Numerous factors are taken into consideration during this evaluation, including age, health status, occupation, marital status, and past claims or criminal records. These factors significantly impact the pricing of insurance coverage. Insurance companies carefully assess these risk factors to set premiums that accurately reflect the potential risks associated with each policyholder.
For example, when analyzing travel insurance policies, one can observe that premiums for individuals aged 65 and above are substantially higher compared to younger policyholders. This is due to the assumption that older individuals are more likely to make claims. Similarly, in the context of home insurance, the occupation of the policyholder plays a significant role. For instance, the premium for a musician may be higher than that for a pastor, ‘’holding all other factors constant’’. This difference stems from the perceived higher risk associated with the occupation of a musician.
2. Risk Profile of the Property to be Insured: Insurers consider various critical factors of the property to be insured when determining insurance premiums. This includes the property type, value, location, condition, risk management practices, and other characteristics of the property to be insured. For instance, in fire insurance policies, aspects such as the age, building materials, occupancy type, location, maintenance practices, and security measures ( alarm systems and CCTV cameras) all influence the assessment of risk and the corresponding premium rates. Premiums for commercial properties, given their higher exposure to risk, are typically higher compared to premiums for residential properties.
3. Coverage Type and Policy Limits: The amount of insurance coverage and the specified policy limits are crucial factors in determining the insurance premium for policyholders. There is a direct relationship between the extent of coverage, policy limit and the resulting premium amount. Put simply, higher coverage and policy limits lead to higher premiums, while reducing coverage and limits results in lower premiums. For example, in the realm of motor insurance, a comprehensive insurance policy commands a higher premium than a third-party insurance policy due to its more extensive coverage.
Likewise, in home or fire insurance policies, the insured value of a building plays a significant role in determining the premium. A building with a higher value is likely to incur a higher premium compared to one with a lower insured value, assuming all other pertinent factors remain unchanged
4. Deductibles: A deductible, often referred to as excess, constitutes the initial portion of a loss borne by the policyholder in the context of an insurance contract. Typically expressed as a percentage, the deductible serves as the policyholder's financial contribution before the insurance company initiates settlement proceedings. For instance, in a standard private comprehensive motor insurance policy, a common practice is to impose a deductible of 10%. This signifies that any reported loss triggers a deduction of 10% from the claim amount before the insurance company proceeds with settlements.
Opting for a higher deductible emerges as a strategic choice for policyholders seeking to lower their insurance premiums. However, this decision comes with the consequence of the policyholder assuming a more substantial portion of a claim in the event of a loss. To illustrate, consider the comparison between two motor insurance policies: one with a deductible of 50% and the other with a deductible of 10%. In this scenario, the premium for the policy with a 50% deductible is anticipated to be lower. However, it implies that the policyholder is now responsible for bearing 50% of each and every reported loss, with the insurance company only covering the remaining 50%.
Ultimately, the selection of a deductible represents a delicate balance for policyholders, requiring a thoughtful consideration of financial risk tolerance and the desire to manage insurance premiums effectively.
6. Credit Score: Insurers consider the credit score of policyholders in accepting certain high-profile risks which demands high level of commitment from policyholders. A credit score is a numerical expression based on a level analysis of a person's credit files, to represent the creditworthiness of an individual. A credit score is primarily based on a credit report, information typically sourced from credit bureaus. Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers and to mitigate losses due to bad debt. Lenders use credit scores to determine who qualifies for a loan, at what interest rate, and what credit limits. Credit scoring is not limited to banks. Other organizations, such as mobile phone companies, insurance companies and government departments employ the same techniques.
A higher credit score often indicates a lower likelihood of default or missed premium payments, which can translate into lower risk for the insurer. Consequently, policyholders with higher credit scores may be deemed less risky to insure, leading to the potential for lower insurance premiums.
By incorporating credit scores into their underwriting process, insurers aim to better assess the likelihood of policyholders fulfilling their premium obligations and the overall stability of their financial situation.
7. Claims and Loss History of the Policyholder: Past loss and claims history of the policyholder is an important consideration in determining insurance premium. Insurers carefully assess and analyze loss and claims history to determine their loss exposure in the event of a loss and also charge the appropriate premium. A history of high frequency and high severity claims will suggest a higher probability of future occurrence which will attract higher premium.
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10. Market Conditions: Economic conditions, regulatory changes, and industry trends can cause fluctuations in insurance premiums. Staying informed about these external factors is crucial for understanding changes in costs. The market condition can be described as hard and soft market. Under a hard market regime
For example, during a state of higher inflation, insurance companies may have to adjust their premiums to account for the higher cost of claims settlement in other to stay profitable and continue to operate as business.
PREMIUM COMPUTATION FOR MOTOR COMPREHENSIVE INSURANCE POLICY
Motor insurance is a type of insurance policy taken out by drivers and vehicle owners to protect themselves against potential liabilities arising from the use of their vehicles. There are three primary types of motor insurance: Third Party Only, Third Party Fire and Theft, and Comprehensive. The Third Party Only policy provides coverage solely for third-party liabilities, including injury, death, or property damage. Third Party Fire and Theft is an extension of the Third Party Only policy, offering additional coverage for damage to the insured vehicle caused by fire or theft.
Motor Comprehensive insurance policy is a type of motor insurance policy that offers a wide range of coverage for vehicle owners. In addition to the damages covered under a third-party fire and theft policy, it goes further by providing coverage for damage to the policyholder's vehicle resulting from collisions and overturning. Despite its wider coverage, there are specific exceptions and exclusions to be aware of which is highlighted in the next section.
Wider coverage comes at a higher premium compared to third party only and third-party fire and theft. The premium for comprehensive insurance policy is typically calculated by combining the third-party premium and the own damage premium for the vehicle in question.
A comprehensive policy comes in two options: a standard policy with an excess applicable, and an excess bought or 100% coverage policy. Premiums for 100% coverage policies are generally higher than those for standard coverage. Under excess-applicable policies, the policyholder agrees to bear a percentage or portion of any loss. In the case of private vehicles, this initial percentage is set at 10% for each and every loss On the contrary, on a full cover basis, the insurance firm takes on full accountability for all liabilities without making any deductions.
Sample Premium Computation for Motor Comprehensive Insurance Policy
VEHICLE DETAILS
Make: Hyundai Elantra
Usage: Private
Year of Manufacturing: 2015
Number of Seats: 5
Vehicle Value :GHS 100,000.00
PREMIUM COMPUTATION
Gross Premium: 5% of Vehicle Value = GHS 5.000.00
Add Third Party Premium (NIC Tariff)= GHS 482.00
Add Excess Bought Premium:
10% of Gross premium (10% of 5,000) = GHS 500.00
Total Premium Payable = 5000+482+500 = GHS 5,982.00
From the above calculation, the premium payable for a full comprehensive cover with a sum insured of GHS 100,000.00 is GHS 5,982.00. Under this cover, the insurance company is fully liable in compensating the insured for any valid own damage claim without any deductible.
Conclusion
Understanding insurance premiums, what influences it and how it is calculated empowers policyholders to make informed decisions and actively manage their insurance expenses. By grasping the factors that influence premiums and implementing strategies to manage them, policyholders can strike a balance between comprehensive insurance coverage and financial competence.
REFERENCES
Motor Vehicle Third Party Insurance Act 1958, 1958
Akyin-Arkoh B. (2024), Ghana’s Insurance Landscape, A Comprehensive Guide to General Insurance, Accra-Ghana
Bancassurance Relationship Manager at StarLife Assurance Company Ltd.
10moGreat teaching Ben.Well done