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How insurers calculate your home insurance premium

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How is home insurance determined? It's complicated. For insurance companies, there's a fine line between pricing competitively and losing money. Price too high, and they lose their customers to the competition. Price too low, and unexpected losses may leave them unable to pay claims -- and put them out of business.

For this reason, insurers continuously analyze their loss data (or pay companies called rating bureaus to collect and analyze data for them), determining which homeowner characteristics are most likely to result in claims, so they can price their products correctly.

How is home insurance calculated?

If and insurer wants to set its premium for a group of homeowners, it first divides the losses associated with that group by its exposure (the amount of property value insured). If during the previous year, the losses for properties valued at $100 million totaled $500,000, that result would be .5 cent per dollar of property value, just to cover losses. This figure is called a "pure premium."

Next, the insurer determines its administrative and other costs, like commissions and taxes, and builds in its desired profit. That is usually expressed as a percentage and is called the "expense ratio." Dividing the pure premium by 1 - the expense ratio generates the gross premium, which is what customers pay.

If the insurer's expense ratio is 27.6 percent, the industry average according to the National Association of Insurance Commissioners, the gross premium would be .5 cents / (1 - .276), or .69 cent for every dollar insured. That's an annual premium of $690 for every $100,000 of coverage.

Why is my homeowners insurance so high?

Homeowners insurance premiums are determined by many factors, and insurers use proprietary software programs to calculate a home insurance rate increase (or decrease).Insurers set rates

How much does each factor contribute to your insurance cost? That's not something an insurer will tell you - how they manage their risk and pricing is a trade secret that even their own agents and brokers are not privy to.

David Melzer of East Insurance Group in Baltimore, Md., says agents submit applicants' information to insurers, it's processed by underwriting software, which generates a 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 that insurance carriers are aggressively trying to take business from other carriers, and are willing to cut prices to get the business," Melzer explains. "They keep their algorithms top secret. We did business with a carrier that had a guy in a windowless cubicle in Timonium. His whole job was to figure out how that carrier's rates compared to the other top five carriers and keep the company competitive in the categories it wanted to insure. Carriers definitely change their rates a lot to get business in different categories. One day, they want couples aged 50 with young drivers and another day they want single women under 30. The same is true with neighborhoods. The computer tries to balance the risk pool."

How to lower homeowners insurance costs

Everyone wants to know how to reduce homeowners insurance premiums. There are several ways to save money on insurance - any insurance - and others that pertain only to homeowners coverage. 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 will almost always pay less by buying more than one policy from a single insurer. This is called bundling. When you shop for coverage, shop all your coverage - auto, home, life, etc., and compare the bottom line price for everything.
  • Go through the factors listed in the section below with your agent, and see which ones you can improve, and how much of a discount you might get.

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 percent discount on your premium), motion-sensing lights, and upgraded locks, windows and doors.

  • Don't insure for your home's purchase price if much of its value comes from the land. If the place burned down, you'd be rebuilding your structure and replacing landscaping - but the actual land does not need to be insured. If you have a home appraisal, it should list the value of the improvements - the things you'd have to pay to replace. That's a good starting point for determining the amount of coverage you actually require.
  • You can 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 Melzer says that some insurers' software is designed to offer lower rates to those with this coverage. "We're told that umbrella policy holders 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 5 to 20 percent off some or all of your homeowners insurance premium.

Homeowners insurance premiums are determined by many factors

As noted above, the way insurers weigh these factors when setting rates is ever-changing and a highly-guarded secret, 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 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 (dog with bite history or breeds considered more dangerous can increase rates)
  • Owner's credit score (statistics show that people with lower score 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 hate your Rottweiler or neighborhood at all, and you could pay less for your coverage.

How to save money on homeowners insurance

There are many things you can do to reduce your home's risk and lower your premiums. However, homeowners insurance costs vary widely among providers, and one of the best things you can do is to get multiple quotes from competing companies. Pricing changes all the time as insurers adjust their portfolios.

"A good strategy is to call multiple times for a quote. If, by chance, the customer falls into the demographic that the computer wants, the insurer may offer a lower price. I know one fellow who was offered a lower quote three times until he bought. This was over a period of two days. He was an 'under 25 single man.' It seems counter-intuitive, but that's what happened," says Meltzer.

Insurers use different methods to set prices so it's important to shop around when looking for home insurance.