If your insurance rates have increased over the past few years you may be wondering why. You may be the perfect customer with no history of claims in the past and wonder why your rates have gone up. It's a very common question so I put together the following for you.
The largest component of your insurance premium goes toward paying claims. All insurance companies measure their claims paying ability by a measurement tool called a "combined ratio". What this tool measures is how much of a dollar that an insurance company takes in goes out the door to pay claims.
What you may be surprised to know is that their is a direct correlation between claims and the economy. How so? The higher the unemployment, mortgage defaults, underemployment etc the more claims that insurance companies receive. I am not implying that everyone that is having financial hardship is turning in bogus claims but the data directly supports my point.
Of course there are other components which go into the cost of insurance. Recently I had a client who experienced a total loss of their home due to a fire. It was amazing how much the cost of construction and materials have gone up in the past couple of years. The cost of gas has impacted the cost of materials from lumber to shingles.
Now lets go back to the discussion on combined ratios. Many insurers have ratios in the low 90% level. What that means is that at a 92% ratio, for every dollar that comes in, .92 goes back out the door to pay claims and provide the service. In this example, the insurer is making an 8% profit. Since all insurance companies run on the same or a similar type of measurement, when claims go up, rates go up. The good news is also that when claims go down, rates go down.
Now there are also other factors that impact insurance rates like natural disasters. Most insurance companies segment their business by state or regions as individual companies which are subsidiaries of the umbrella entity. Insurers typically structure their business this way so that should one state or region experience a catastrophic loss, other states do not end up subsidizing the loss. In other words, when hurricane Ike hit the coast a few weeks ago, the individual regions where the devastation occurred will experience financial losses but the larger entity is still intact. This protects both the risk and helps insurers demonstrate impacts or poor financial performance to the pointy heads on wall street. I do want to point out that this segmentation in no way is created to allow any individual insurers to walk away from their claims commitments in states or regions that have experienced a natural disaster. There are quite a few safeguards in place which prevent this from happening..
Why do insurers use this type of methodology? The claims paying ability of the insurer must be sound at all times. Look at the scare that AIG sent thru the market this week with the potential of a default. Now, AIG's problems were more a result of their investments vs. a combined ratio issue. My point here is that your insurance company must be sound financially.
We will see brighter days in the future as our economy starts to turn the corner. I know this is a fairly brief explanation of the rate issue but I did want to give you the inside scoop. So I guess that's all I have to say about it. I hope you enjoy.
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