Each insurance company has its own proprietary formula to help determine its risk or exposure, which results in your premium. These different formulas are why results vary widely when you receive quotes from multiple insurance companies. Most of these formulas, though, are some variation of what is known as the pure premium method. This method is how your rates are calculated. The pure premium method provides the insurance company the ability to cover any losses you may suffer as well as a profit.
Estimate your pure premium. A pure premium rate is an estimate of the amount an insurance company needs to collect to offset any potential claim on your policy. To estimate this, take your potential loss and divide by the insurance's exposure unit. For example, if your home is valued at $500,000 and the exposure unit is $10,000, then your pure premium would be $50 ($500,000 / $10,000).
Determine the fixed expenses per exposure unit. An exposure unit is an incremental unit of measure that correlates the premium charged to the amount of any legal fees or taxes that result from the claim. A couple of examples of an exposure unit include per $1,000 of property value or per $1 per square foot area of property. This is also an estimate of the insurance company. This is estimated based upon prior, similar claims. If a home similar to yours in size and location home has had $300,000 worth of expenses due to a claim, then you could estimate that your fixed expense per exposure unit is $300,000 / $10,000 or $30. Your policy should list the amount of your exposure unit. If you cannot find the exposure unit on your policy, call your insurance agent to determine the amount.
Estimate the variable expense factor. This factor is the sum of all expenses associated with the policy. Some examples of these expenses include sales commissions, taxes and marketing expenses. A standard variable expense factor estimate is 15 percent.
Estimate the profit and contingency factor. This is the factor that insurance companies use to hopefully ensure profits and protect themselves against any fraudulent claims. Insurance companies typically use a range between 3 to 5 percent for a profit and contingency factor.
Assign each of the numbers a variable. P = pure premium. F = fixed expenses per exposure unit. V = variable expense factor. C = contingency and profit factor.
Place your numbers into the following equation: Your rate = (P+F)/1-V-C. If you continue the example and assign 4 percent as the profit and contingency factor, the equation would be ($50 + $30) / 1 - 0.15 - 0.04) or $80 / 0.81. Your rate would be $98.77. Multiply this number by 12 to find your annual rate, which would be $1,185.24 in this example.