How is home insurance calculated?

Home insurance premiums can be confusing, and many factors go into the premium you pay. Just how is home insurance calculated? Insurance companies use complex systems, but what it comes down to is the risk of a claim.

Insurers use data about past claims and construction cost data to look at everything from the weather in a particular ZIP code to replacing a granite countertop. Home insurance calculators available to the public use similar but usually more simplified approaches. In addition, the company’s operating costs are part of the formula.

Read on to learn more about the factors used to calculate home insurance rates and what you can do to get cheaper home insurance.

What is a home insurance premium?

Your premium is what you pay for coverage, also called your homeowners insurance rate. Home insurance premiums are calculated on an annual basis and reviewed each year. Premiums change annually following the cost of construction and other factors.

How is homeowners insurance calculated?

A home insurance calculator categorizes policyholders by area and risk exposure (the level of risk they are taking). Here are the steps insurance companies use to calculate home insurance premiums:

1. Find the pure premium

If an insurer wants to set its premium for a group of homeowners, it first divides the losses associated with that group by its exposure. If, during the previous year, the losses for properties valued at $100 million totaled $500,000, that result would be 5% or five cents per dollar of property value, just to cover losses (what is paid out in claims.) This figure is called a "pure premium."

2. Calculate the expense ratio

Next, the insurer determines its administrative and other costs, like commissions paid to agents, maintaining office buildings, paying support staff and even taxes. It then builds in its desired profit to set how much the company needs to make after paying all of the costs associated with doing business. That is usually expressed as a percentage called the "expense ratio." 26.5% is the industry average, according to S&P Global.

3. Set the final premium

Insurance companies use a calculation of the pure premium and the expense ratio to get the gross premium. That's sort of a base rate for home insurance in your area. From there, that premium will be adjusted based on your factors, including things like your credit score, claims history and the breed of dog you own.

What is the formula for calculating homeowners insurance?

If you felt confused reading about how insurers calculate home insurance premiums, you're not alone. However, there is a way you can come up with your own quick estimate using a basic insurance premium formula.

Multiplying the home's square footage by the cost to rebuild is a quick way to determine how much dwelling coverage you'll need. For example, let's assume your home is 2000 square feet and the average cost to build per square foot is $150 (this cost will vary depending on your location, home type, etc.) So, 2000 X $150 = $300,000 dwelling coverage.

Since we recommend insuring 100% of your rebuild cost, plug that dwelling coverage number into our home insurance calculator along with your ZIP code, liability coverage amount and chosen deductible. You'll then be given average home insurance costs.

How much should homeowners insurance increase each year?

There's no set amount for annual increases, as it depends on a lot of factors. Home insurance follows inflation but may not go up exactly in line with overall inflation. That's because the cost of construction materials may rise at a higher rate. Insurance companies will also adjust for claims paid, both claims you have filed and claims filed in your neighborhood that indicate a higher risk.

In addition, any changes you have made to the home will affect your rates. That includes renovations and additions, or even things that increase the risk, like adding a swimming pool.

How to lower homeowners insurance

There are several ways to save money on home insurance. First, try the same methods you'd use to save on auto insurance:

• Ask how much you can lower your premium by raising your deductible. You won't want to make multiple small claims anyway, so paying for coverage you're unlikely to use isn't always the best use for your insurance dollars.
• You might pay less by bundling your coverage with one insurance company.
• Ask about discounts. There aren’t as many discounts for home insurance, but some are pretty big.

Next, look at these tips specific to homeowners insurance.

• Consider making your home safer with a monitored security system (studies show that this can get you a 20% discount on your premium), motion-sensing lights, and upgraded locks, windows and doors.
• Don't insure for your home's purchase price. If the house burned down, you'd be rebuilding your structure and replacing landscaping - but the actual land does not need to be insured. Insure your home for the calculated replacement cost instead.
• Request a Comprehensive Loss Underwriting Exchange (C.L.U.E.) report for your property. If the cause of claims by the previous owner has not been resolved, your own rates could be affected. If it has been resolved, you can have the report corrected, saving you (and subsequent owners) on home insurance premiums. To fix an error, fill out the form on LexisNexis, the company that compiles C.L.U.E. data, or call them at 800-456-6004.
• You should also request your personal C.L.U.E. report, which contains your personal claims history. Review it for errors - like a credit report, it may not be accurate, and fixable mistakes could be costing you.
• Look into umbrella coverage for extra liability protection. It's relatively cheap (usually between $200 and $300 per year), and Meltzer says that some insurers' software is designed to offer lower rates to those with this coverage. "We're told that umbrella policyholders are viewed as more responsible," he says.
• Finally, if you're willing to give up some information to your insurer, it may reward you. Similar to the "black boxes" some drivers install on their cars in exchange for lower car insurance premiums, "smart" home products, including security cameras, thermostats, carbon monoxide, and fire detectors can net you up to 20% off some or all of your homeowners insurance premium.
• Look to home improvements to lower insurance. Updating your roof or adding weather protection like storm shutters can reduce your rates.

What determines home insurance rates?

How is homeowners insurance calculated?

David Meltzer of East Insurance Group in Baltimore, Maryland, says underwriting software generates the rate. "We're able to advocate for the insured when there's a claim, but the days of agents setting rates for clients have long passed."

Furthermore, insurance pricing is very fluid and changes continuously.

"The thing is, insurance carriers are aggressively trying to take business from other carriers and are willing to cut prices to get the business," Meltzer says. "They keep their algorithms top secret.”

The way insurers weigh these factors when setting rates is ever-changing, but here are common factors that determine rates:

• Replacement cost of the home (higher cost = higher rates)
• Age of the home (newer homes can be cheaper to insure)
• Home square footage (larger homes are more expensive to rebuild and have higher premiums)
• Number of primary inhabitants (larger households increase potential liability)
• Construction type (fire-safe materials like masonry are cheaper to insure than wood)
• Roof type (fire-retardant asphalt or metal is preferable to wood shakes)
• PPC (Public Protection Classification, which measures the proximity of fire station, police, hydrants, etc. A "1" is the best; a "10" is the worst.)
• Area claim history (if neighbors file lots of claims, it can increase your rates)
• Personal claim history (if you file more than average claims, your rates will be higher)
• Pets (a dog with a bite history or breeds considered more dangerous can increase rates)
• Owner's credit score (statistics show that people with lower scores file more insurance claims)
• C.L.U.E. report of the property, which lists claims filed by the previous owners in addition to you. If the cause of the claims has not been resolved, your rates will be higher.
• Security or alarm system (alarms and monitoring help decrease rates)
• Fire alarm system
• Deadbolt locks
• Neighborhood crime rate (higher crime areas cause higher insurance rates)
• Attractive nuisances (swimming pools, ponds, machinery, playground equipment, trampolines) increase liability potential and insurance premiums

If one or more of the factors listed here is costing you money and can't be changed (like your location), check with other insurers. A different company might not rate your Rottweiler or neighborhood the same way, and you could pay less for your coverage.

Frequently asked questions: Calculating home insurance