Car insurance premium to most people is just a number at the bottom of their car insurance bill which is usually larger than they’d like.
The magic behind this number, however, is really an impressive mathematical and analytical feat. The unique thing about it is it’s YOUR number based on many, many different factors.
In this article, you will learn many of the things that go into the rate generation process, but I promise not to get too insurance-geeky or make it difficult to understand.
Brief overview of how premiums are calculated
Car insurance rates are calculated using a combination of individual risk factors like driver age, vehicle type, and driving record, and broader economic factors such as inflation, the cost of healthcare, regulatory changes, and market returns.
Geographical location also impacts insurance calculations, with different risks associated with urban versus rural environments.
Technological advancements, such as the use of telematics, are increasingly being leveraged to offer more personalized rates based on actual driving behavior.
The objective in calculating car insurance rates is to maintain a fair balance—ensuring that premiums are equitable for the risk covered, while also providing comprehensive protection to policyholders.
Ever heard of an actuary? You have now!
Actuaries play a critical role in this process, analyzing statistical data to gauge the likelihood of a driver filing a claim.
In the context of car insurance, actuaries help determine the company’s policy pricing structure by assessing the likelihood of future claims and setting premiums that are sufficient to cover these claims, while also ensuring that the insurance company remains profitable and financially sound.
In simpler terms, an actuary sets the price so the insurance company makes money.
The basic car insurance formula
Believe it or not, there is a simple formula for determining how much car insurance costs:
Premium = (Frequency of Claims) × (Average Cost per Claim) × (Risk Factor) + (Insurance Company Expenses) + (Profit Margin)
Here’s what each component represents:
- Frequency of Claims – This is the expected number of claims that the insurer anticipates over a certain period. Actuaries use historical data to estimate this frequency for different categories of insured drivers.
- Average Cost per Claim – This is an estimate of how much the insurance company expects to pay out for each claim. It can be influenced by factors such as vehicle value, costs of repairs, medical expenses, and legal fees.
- Risk Factor – This is a multiplier based on the individual policyholder’s risk profile. Actuaries determine this by analyzing variables such as the driver’s age, driving record, credit history, and even geographic location.
- Insurance Company Expenses – This component covers the insurer’s operational costs, including employee salaries, marketing, and administrative expenses.
- Profit Margin – Insurers add a margin to ensure profitability and financial stability.
Actuaries adjust the weight of each component based on complex statistical models and predictive analytics (yes, I know I promised not to get too geeky).
The premium calculation also includes considerations for the competitive landscape of the insurance market, regulatory constraints, and the desired business outcomes of the insurance company.
Now keep in mind that this formula is the simplified version of a very complex formula. We are only going to go into detail discussing the Risk Factor component as it pertains to you, the driver, as the other data in the formula would put you to sleep faster than a politician changes his mind.
First, though, we want to mention a concept called risk pooling because without it, car insurance would not exist.
Risk pooling: A marvelous concept that makes insurance possible
The concept of risk pooling is a fundamental principle in the field of insurance. It involves combining the risks of many individuals into one pool.
This way, the impact of potentially large losses that individuals face (such as those arising from car accidents) is spread out over a larger group of policyholders.
Here’s how it works:
- Collective Sharing of Risk – Instead of each person having to bear the full financial burden of a significant loss on their own, all members of the pool share in the risks. This means that the losses of the few are covered by the contributions (premiums) of the many.
- Law of Large Numbers – Risk pooling relies on the statistical principle that the larger the group of policyholders, the more predictable the overall loss experience will be. This predictability allows actuaries to estimate more accurately the amount of funds the insurance company needs to cover claims and expenses.
- Diversification of Risk – By insuring a diverse set of policyholders and risks, the insurance company can stabilize the loss experience. This diversification means that not all policyholders will make claims at the same time or for the same reasons.
- Financial Security for Individuals – By paying a relatively small premium, each policyholder gains financial security and peace of mind, knowing that they are protected against the financial impacts of significant and unpredictable losses.
In essence, risk pooling enables insurance companies to operate effectively by reducing the uncertainty of individual risks.
It’s the mechanism that makes it possible for insurance companies to offer coverage at a price that is affordable to consumers while still ensuring that funds will be available to pay for covered losses as they occur.
Risk factors that affect the cost of car insurance
Ok, here is where we start to break out some of the more interesting stuff that goes into rate calculations that is probably more relatable for you.
Factors like your age and gender, driving history, marital status, vehicle make and model, credit score, and location all play a part in coming up with that big, fat amount you pay every month for car insurance.
We aren’t going to go into a lot of detail on each risk factor since we cover that in more detail in the next article in our Car Insurance 101 educational series: Factors That Affect Car Insurance Rates.
The point here is to cover a lot of factors quickly so you can get a picture of how complex the calculation of car insurance premium truly is.
These five types of risk factors we will cover are: personal, vehicle, geographic, financial, and policy-specific.
Personal risk factors
Personal risk factors are individual characteristics that insurers evaluate to determine the likelihood of a policyholder filing a claim. These factors include age, gender, driving history, and marital status.
- Driver Age – Car insurance premiums are heavily influenced by the driver’s age. High rates for young drivers reflect their inexperience and propensity for risk. Middle-aged drivers usually pay less, as their experience translates to fewer claims. Yet, for seniors, rates may increase with concerns over age-related driving skill decline.
- Driver Gender – Traditionally, car insurance rates have differed by gender, with men, particularly young males, paying more due to higher risk and accident rates. Women often enjoyed lower premiums linked to fewer claims.
- Driving Record – A spotless driving record can lead to lower insurance premiums, while violations or accidents indicate higher risk and raise rates. Insurers use driving history to forecast future risk, so a clean record is key to low-cost insurance.
- Marital Status – Married individuals typically enjoy lower car insurance rates than singles, reflecting data indicating they have fewer accidents and claims. However, the weight of marital status on premiums may differ by company and region.
Vehicle-related risk factors
Vehicle-related factors are related to the performance and safety features of your vehicle. Also included are things like the cost of repair parts, how you use your vehicle, and how much you drive.
- Make and Model of Your Vehicle – Car insurance rates vary with the vehicle’s make and model, driven by repair costs, safety, and theft likelihood. Luxury and sports cars, with costly parts and theft appeal, face higher premiums. Meanwhile, safety-equipped cars attract lower rates, with good crash-test outcomes potentially reducing claims and insurance costs.
- Mileage Driven – Higher annual mileage generally leads to increased insurance costs due to greater accident risk from more time on the road. Cars driven less often may benefit from low-mileage discounts. Additionally, insurance rates can vary based on the car’s primary use, with commuting in heavy traffic being riskier, and thus potentially more expensive to insure, than occasional leisure driving.
- How You Use Your Vehicle – Using your car for business purposes can lead to higher car insurance premiums compared to personal use. This is because business use typically involves more travel, often at peak accident-prone hours and on busier routes, increasing the risk of claims.
Geographic risk factors
Where you live has a significant impact on the price you pay for car insurance. Urban areas, high-crime neighborhoods, high likelihood of weather events, and unfavorable state insurance laws all have a negative impact on rates.
- Urban vs. Rural – Car insurance often costs more in urban areas compared to rural regions due to the increased risks associated with city driving. Urban drivers face heavier traffic, higher accident rates, and a greater likelihood of vehicle theft and vandalism, all of which elevate the chance of filing a claim.
- Crime, Theft, and Vandalism – Crime rates, especially for theft and vandalism, can significantly impact car insurance rates. In areas where these crimes are more prevalent, the risk of a car being broken into, stolen, or damaged is higher. Insurers often charge higher premiums in high-crime areas to offset the increased risk.
- Weather Events – Regions prone to severe weather conditions can see higher car insurance rates due to the increased risk of damage from natural events. Heavy snowfall, hailstorms, and other extreme weather can cause significant damage to vehicles, leading to a higher number of insurance claims.
- Natural Disasters – Earthquakes, floods, hurricanes, and wildfires can lead to total vehicle losses, which, in turn, result in significant insurance payouts. As insurers must balance their risk exposure, they often raise premiums in regions where such catastrophic events are more common.
- State Insurance Laws – States with higher minimum coverage requirements drive up the cost of insurance policies to meet these regulations. Furthermore, states that adopt no-fault systems can have higher premiums because insurers provide coverage for their policyholder’s injuries regardless of fault, which can lead to more frequent claims.
Financial risk factors
Financial risk involves things like how well you maintain your credit score or financial responsibility. Also included is your propensity to file claims.
- Credit History – Higher credit scores are linked to safer driving and fewer claims, leading to lower car insurance premiums. Those with lower scores face higher rates due to perceived increased risks. Some states ban credit-based insurance pricing amid fairness and discrimination concerns.
- Insurance Score – Your insurance score, which is partially influenced by your credit history, plays a significant role in determining car insurance rates. This score is used by insurers as an indicator of how likely you are to file a claim. Higher insurance score suggests financial stability and responsible behavior, which translates to lower risk for the insurer.
- Claim History – Insurance companies view past claims as indicative of future risk. A history of frequent claims can suggest a higher likelihood of future incidents, prompting insurers to charge higher premiums to cover the anticipated costs.
Policy-specific risk factors
The factors consist of the type and amount of coverage you buy. This includes your choice of comprehensive and collision deductible, liability limits, and other optional coverages you may have on your policy.
- Liability Limits – Choosing higher liability limits on your car insurance policy generally results in a higher premium because it increases the maximum amount your insurer will pay out for a claim. While higher liability limits can elevate the cost of your insurance, they also provide greater financial security.
- Physical Damage Coverage – Adding physical damage coverage, which includes collision and comprehensive insurance, to your car insurance policy typically raises the cost of your premium. Since these coverages mean the insurer might have to pay for repairs or even the total value of your car, they represent an increased risk to the insurance company. Consequently, the more protection you add, the more you’ll pay for the insurance policy.
- Deductible Choice – Selecting a higher deductible on your car insurance policy lowers your premium since you assume more cost if you file a claim. Conversely, a lower deductible raises your premium as it increases the insurer’s potential payout.
- Optional Coverages – Uninsured/underinsured motorist coverage and medical payments and PIP coverage is optional in some states and adding them increases policy cost. Additionally, adding roadside assistance, new car replacement, gap insurance, accident forgiveness, or glass coverage will all increase the cost of a policy due to the additional risk the insurance company assumes.
See Drive Your Car Insurance Cost Down: Understanding Rate Factors for an in-depth look at how car insurance premium is calculated as part of our Car Insurance 101 Educational Series.
The checks and balances of car insurance rate setting
Even after an insurance company’s actuarial department takes all the above factors into consideration and sets appropriate rates, the company still has to file rate changes with their state insurance regulators and obtain approval before any changes are made.
The state evaluates these submissions to ensure that the rates are neither excessively high nor insufficient to maintain the insurer’s solvency and capability to pay claims.
The state regulators check for compliance with legal statutes and actuarial standards, looking to confirm that rates are adequate, not discriminatory, and not unfairly burdensome to consumers.
They aim to maintain a competitive market, prevent price gouging, and protect consumers from unjustified rate increases while also ensuring that the insurance companies remain financially healthy enough to serve their policyholders.
This regulatory oversight means that even if an insurance company wishes to raise rates due to increased risks or losses, the increase must be justified and approved by the state.
This process can lead to either the acceptance, adjustment, or denial of proposed rate changes, directly influencing the car insurance rates that consumers pay.
How technology is changing actuarial science
The landscape of car insurance is being transformed by rapid advancements in technology and data analytics, leading to more nuanced and personalized insurance rate calculations.
In the traditional model, insurers used broad demographic factors like age, gender, location, and vehicle type to estimate risk. Now, with big data and advanced analytics, insurers can assess risk with greater precision and tailor premiums more closely to individual behaviors and circumstances.
Telematics is revolutionizing personalized car insurance rates
Telematics is a prime example of this shift. Usage-based insurance (UBI) programs utilize in-car devices that monitor driving behavior in real time, gathering data on speed, braking patterns, mileage, and time of day when the vehicle is in use.
This information allows insurers to assess risk at a granular level and offer personalized rates. Safe drivers can benefit from lower premiums by allowing their insurers to track their driving habits and demonstrate their low-risk behavior.
Machine learning and AI are the next frontier
Machine learning algorithms, capable of analyzing vast datasets to uncover subtle correlations that humans might miss.
By integrating more complex variables, such as social media activity or shopping behaviors, insurers can predict risks and customize premiums with unprecedented specificity. We won’t go into the can of worms about the privacy concerns that the use of this technology could create.
The integration of artificial intelligence (AI) extends to customer service as well, with chatbots and virtual assistants able to handle claims and inquiries, leading to more efficient operations and potentially lower costs.
AI can also aid in fraud detection, saving companies millions and, indirectly, reducing costs for policyholders.
However, with the rise of autonomous vehicles and advanced driver-assistance systems (ADAS), traditional risk assessment models are challenged.
As cars become safer and driver input decreases, the responsibility may shift from driver behavior to vehicle technology and manufacturer liability, potentially upending the way premiums are calculated.
Technology and data analytics are not just incrementally changing the insurance business. They are revolutionizing it.
These advancements lead to more personalized premiums, better customer experiences, and potentially safer roads. As insurers become increasingly adept at leveraging technology, the car insurance industry stands on the cusp of a more efficient, equitable, and adaptive future.
About the Author
During his career as an independent insurance agent, Ryan Grabenstein was appointed with Progressive, Allstate, Nationwide, Travelers, and many smaller regional and mutual companies. He has a Bachelor's degree in Finance from the University of Nebraska at Lincoln and Certified Insurance Counselor (CIC) personal and commercial lines training.