Sunday, January 11, 2009

Insurance Rates – How they are determined

As my prior posts explain, I was able to save $600 per year by moving my family's auto insurance from my old carrier to USAA. While it might be tempting to say my prior carrier was trying to gouge me, the reality is their pricing for "my family" just was not as competitive as USAA's. To explain how this occurred, I have written a simplified explanation of how insurance companies determine their rates.

All insurance companies have teams of employees who work as actuaries. They are the bean counters who determine what the company will charge for each potential customer. Their goal is to predict, as accurately as possible, the expected losses the carrier will face from each customer. Once loss costs are estimated, the company will build out its rate quote based upon expected loss costs, expense load, and cost of capital. Obviously, companies with lower cost structures will have a competitive advantage.

While some consumers think there is a grand conspiracy to "get it wrong" and quote the highest rate possible that is simply not the case. If a carrier systematically gets it wrong and quotes higher prices than are necessary, they will lose business to other carriers willing to charge lower rates. If a carrier systematically gets it wrong and quotes rates inadequate to provide a reasonable profit, they take heavy losses and go out of business.

How could USAA charge $600 less than my old carrier?

Simply put, their model predicted lower losses on Toyota Corollas than did my former carrier's model. Why? I have no idea. If USAA's actuaries built the best model for Corollas, they will make a profit off my business. If not, they will lose money on consumers who drive Corollas.

The Model's Change: As a consumer, our job is to get the best combination of price and service for our premium dollar. Good carriers are constantly tweaking their model's looking for better results. For that reason, USAA may not always be the lowest price carrier for my family. Every so often, consumers should shop their coverage to make sure they are getting the best price for them.


Although it is tempting to say they are "all the same," I can say with 100% confidence they are not. Before moving your policy to any carrier, research their claims handling and service reputation. Some smaller carriers are a nightmare to deal with. I would not wish them upon my worst enemy.


* Note – in many jurisdictions, insurance companies must have their rates "approved" by the state. Because the rate approval process can distort real economics in a myriad of ways, this post does not address the impact of regulation on rates. Having said that, years of working in the insurance industry tells me rate regulation leads to higher prices.

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