Calculation of insurance premium

In a competitive market, an insurer has to calculate its premium at a level that is just sufficent to pay the expected claims, expenses and provide a small margin of profit.

The expected claims is about 70% of the premium (also called the claim ratio), with the difference of 30% (also called the loading) being reserved for expenses and profit.

If the financial accounts show a claim ratio of 70% for a class of business, the premium rate is at the right level. If the claim ratio is less than 50%, the insurer is making an excessive profit margin by charging a high premium (relative to the expected claims).

If there is intense competition, the premium rate may be pushed down to a low level, resulting in a claim ratio higher than 70%. The insurance company is making a loss, and has to increase the premium rate in the future.

For example, take the case of term insurance covering $300,000 for young people with an average claim rate of 0.1% (say). The average claim per person is $300. Allowing for a loading of 30% (to cover expenses and profit), the premium charged per person should be $428.

An insurer is able to charge a higher premium rate and enjoy a bigger profit margin by designing a product that is not easy to be compared against similar products in the market. The insurer train the agents to sell the products, in spite of its higher price.

Customers should avoid insurance products that are not easy to compare and are marketed by agents who earn a high rate of commission. They should look behind the marketing presentation of the product to see what is the underlying claim ratio.

Tan Kin Lian