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Auto Insurance Premium

Written by Todd Clay. Posted in Definitions Last Updated: 10/29/2010

What is car insurance premium, why it’s different for policyholders, and what it pays for.

car keys and hundred dollar bills

Now you have the keys, you'll have to pay for insurance.

Perhaps no insurance term creates more interest or controversy than “premium.” Premium is the money you pay to your insurance company for your car insurance policy.

Everyone knows they have to pay it. Everyone wants to save as much as possible on premium. But what does premium do?

Premiums Are Different for Policyholders

Strictly speaking, insurance is communally financed by premiums paid by all policyholders. This financing in turn pays for claims. How much a particular policyholder pays is based largely on risk. Policyholders deemed riskier pay more than those who are considered less risky. There’s nothing particularly earth-shattering about any of that.

Premiums are determined by specialized insurance company employees called actuaries. Actuaries are experts in statistics who determine premium rates based on factors such as risk exposure, claims history and business concerns. These rates are then approved by the company’s board of directors.

Premiums Go To Insurer’s Reserves

By far the largest portion of your premium, well over 60 percent of it in most cases, goes towards a company’s fund to pay out claims. Since the primary function of an insurance company is to pay legitimate claims, this is taken very seriously.

Insurance companies are required by law to keep a certain amount of cash on hand at all time for claims. This amount is based on company size and amount of policies in force, but it is invariably quite substantial.

If a company drops below its acceptable cash on hand, it can face increasing sanctions from the state, up to and including receivership and dissolution. Accordingly most companies keep cash reserves well in excess of what the state tells them they need.

Third party rating companies such as A. M. Best annually rate insurance companies on their financial strength. Claims-paying ability is preeminent in the factors they look at. These ratings, such as A++ and A+ for companies in outstanding financial shape, are made available to the general public. Most insurance companies are quite proud of these ratings and use them in their marketing campaigns.

Commissions Paid By Premiums

Another significant cost of insurance is agent commission. Agents typically work for insurance companies as independent contractors. Their compensation from the insurance company is in many cases is based solely on commission.

Agent commissions for most auto insurance and other property and casualty lines usually range from six to 12 percent of total premium. The exact amount is determined by several factors, including product sold, whether the policy is new business or a renewal, and perhaps the agent’s past sales performance.

Some companies cut out the agent and sell directly to the consumer via the Internet or other means. While this can result in some cost savings to the consumer, that’s not necessarily the case.

Many companies have figured out that cutting out the middleman leads to increased profits for them, as consumers are used to paying premium prices that take agent commissions into consideration. The result can be a lack of service, as the policyholder has no agent to turn to in these situations.

Premiums Pay Other Costs

Most of the rest of your premium dollar goes towards company operating costs such as salaries for home office staff, building maintenance, and other factors. Premiums are regulated by state governments, but states give companies enough leeway to allow them compete in a free market.

As a result companies with similar financial strength ratings can offer very different premiums for similar coverages. You will pay premiums if you have insurance. That’s why it pays to shop around.

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Todd Clay

Todd Clay is a former insurance agent with the largest insurance company in the United States. He earned his Bachelor’s from the University of Texas. He's worked in several fields but has specialized in insurance, financial-related information, and technology. He blogs at Car Insurance Guidebook. Connect with Tood on Google+

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