Pricing Insurance - How is it done?

Pricing an insurance product, like an auto or homeowners policy, differs from pricing products in most other industries.

Traditional Pricing vs. Insurance Pricing

  • Traditional Pricing: In most industries, you know all your costs upfront—production, marketing, delivery, etc. This allows you to set a fixed profit margin, ensuring predictable profits.
  • Insurance Pricing: In insurance, costs and profits are not known upfront. Instead, rates and premiums are predicted before the coverage period begins.

Components of Insurance Rates

Insurance rates are made up of three primary components:

  1. Company Expenses
    • Commissions: Payments to agents (e.g., 15% of the premium).
    • Taxes and Fees: Regulatory costs.
    • General Operating Expenses: Overhead costs like salaries, rent, and utilities.
    • Predictability: These expenses are stable and easier to predict.
  1. Expected Losses
    • Claims Payments: Money paid out to policyholders for covered losses.
    • Influencing Factors:
      • Weather events like tornadoes and hail.
      • Driving patterns and accident rates.
    • Challenge: This portion is hard to predict and varies greatly.
  1. Provision for Profit
    • A margin added to cover profit expectations.

Predicting Future Costs

Insurance companies use historical data and make future adjustments to set rates:

  • Historical Data: Analyzing past claims to identify patterns and trends.
  • Adjustments: Considering factors like inflation and changing settlement patterns.
  • Challenges: Predicting future weather events, driving patterns, and economic conditions is complex and not an exact science.

Example: Homeowners Insurance in Oklahoma

In areas with unpredictable weather, such as Oklahoma:

  • Past Data: Companies analyze previous weather-related losses (e.g., tornadoes, straight-line winds, hail).
  • Adjustments: Adjust these losses for inflation and economic changes.
  • Future Predictions: Estimate the likelihood of similar events occurring in the future.


Insurance pricing is a complex process involving the prediction of future expenses and losses based on historical data and expected trends. While company expenses are stable and predictable, the loss portion is variable, making insurance pricing uniquely challenging.