The Science of Home Insurance

As a consumer of home insurance, you may have wondered about the factors involved in how the product is priced and whether or not it’s a reasonable cost. Many factors are involved in the home insurance process, and it may surprise you that insurance companies don’t always make a tremendous profit from the business. As an individual consumer, it may seem that you pay a lot for each year’s insurance and do not always make a claim, thereby not getting your money’s worth. However, when you have a better understanding of all that goes into the home insurance business, you might better appreciate the risk your insurance company takes on your behalf and the value proposition of home insurance.

In its simplest terms, the insurance company collects premium from all of its policyholders and then pays claims from, hopefully, a smaller subset of all those policyholders. This is part of the basic insurance principle of pooled risk. While any one person may always have the probability of generating a claim, statistically, the likelihood of every one of those people generating a claim is fairly low. The insurance company works from these statistics to determine its overall probability of paying claims and uses that as a factor in setting premiums.

The insurance business is very largely driven by statistics and the overall financial market performance. Statistics in the insurance business are known as actuarial studies. These are helpful in that the large number of policyholders and claims data can help an insurance company develop, with reasonable confidence, an expectation of how much it will pay in claims. In addition to actuarial science, insurance companies rely on their investments to help generate funds to pay claims. When your insurer collects your insurance premium, it does not immediately pay a claim. Instead, it holds onto your premium dollars for a period of time before they are needed to pay policyholders for their claims. During this period of time, the insurance company can carefully invest the funds to grow them and potentially have more money to pay claims and also generate a profit for its shareholders. In many situations, the investment income makes all the difference in an insurance company’s profitability.

Consequently, when insurance companies evaluate their performance, they often appear to be losing money on a pure underwriting basis. For example, a loss ratio is the comparison of premiums collected versus the claims paid. If a loss ratio is in excess of 1:1, that means the insurance company has paid more in claims than it has collected in premiums. However, many insurance companies are profitable with a higher loss ratio as a result of money they earn on their investments regardless of where the are- Boston, Charlotte, Cleveland, Columbus, Dallas. Therefore, insurance companies do not solely operate on the basis of premiums versus claims.

In addition to their regular statistical analysis, insurance companies have started developing more sophisticated forms of actuarial prediction. Instead of solely relying on the law of large numbers, they have begun to understand that there may be external factors that aren’t always evident when taking a very high level view of their business. For example, an insurance company may have too much of a concentration in one geographic area, leaving it overly exposed to a catastrophe. Over time, their evaluation of their business has evolved to include various risk factors to diversify the policyholders they insure. One of these new techniques is predictive analysis, which is a more sophisticated way of using the statistical data on hand.

As you can see, many factors go into the home insurance business, and the premium you pay is not always strictly driven by your own claims history.


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