The Lazy Economist: How insurance companies work

A look behind the scenes of premiums

Insurance companies base much of their pricing off risk assessments.
Photo: 

Insurance can be a mysterious part of adult life.

Whether it’s car, home, or medical insurance, the basic principle underlying insurance remains the same across all sectors of the market. Like any business, insurance companies want to bring in more money than they spend.

In this case, the cost of enrolling in an insurance plan—a premiumis where the company’s profit is. A cost occurs when the company pays someone that’s making a claim. The amounts paid depend on risk.

Risk refers to the likelihood an insurance company will need to pay out in the event of an emergency. If a company determines there’s a high chance of payment, it can either lower the amount paid-out, or give the client a higher premium for the risk.  

Risk refers to the likelihood an insurance company will need to pay out in the event of an emergency.

Here’s the calculation: someone pays $100 a year to insure a pet cat. If the cat gets sick or injured, the insurance company will pay $400 to help cover the medical bills.

If the cat has a 25 per cent chance of getting sick in a given year, then the insurance company can expect to pay out $100 per year on average. In this case, the company will break even.

If the cat has more than a 25 per cent chance of getting sick—like 40 per cent, for example—then the insurance company will have to pay out $160 per year on average.

This pay out is more than the $100 the person pays for their premium, so the insurance company would be losing money. To make it up, the company will either raise the premium to $160, or reduce the amount of money they would pay if the cat gets sick.

If the cat has less than a 25 per cent chance of getting sick, the insurance company will, on average, pay out less per year than the $100 the cat’s owner pays in their premium. In this case, the company is making money.

These kinds of calculations come up all the time in real life—even if you don’t have a sick cat. For example, this kind of economic reasoning is why it often costs more to buy car insurance as a young driver. Insurance companies have data that indicate young drivers get into crashes more frequently.

To compensate for the increased risk of an inexperienced driver in a car accident, companies charge young drivers a higher premium than more experienced drivers.

If you’re ever wondering why your car insurance is higher than your parents’—or why it might cost more to insure your accident-prone cat—remember it all comes down to risk.

When commenting, be considerate and respectful of writers and fellow commenters. Try to stay on topic. Spam and comments that are hateful or discriminatory will be deleted. Our full commenting policy can be read here.