Health Insurance Blog

Pricing health insurance is a complex process in which many factors are taken into account. An insurer must set a premium amount that both makes the coverage advantageous and attractive to the insured and also enables the insurer to cover its costs and make a profit (for stock companies) or add to surplus (for mutual companies).

However, we can identify four basic principles that an insurer must follow:

• Adequacy: The amount of the premium for any policy must be adequate to cover the benefit payments the insurer makes on the policy and the costs of administering the policy. For a stock company, the premium must also provide a reasonable amount of profit. For a mutual company, it must also provide a contribution to the surplus the company needs to guarantee its obligations and to fund growth and development. If an insurance company’s premiums are not adequate, the company will not be able to meet its costs, it will not be able to make a profit or add to surplus, and it will eventually go out of business.

• Reasonableness: Premium amounts must be reasonable in relation to the coverage provided. In other words, people must feel that the coverage they get from a policy is worth the premiums they pay for it. If an insurer charges too much for its coverages, few people will buy them and the insurer could go out of business.

• Competitiveness: The premium an insurer charges for a coverage must not be significantly higher than the premiums charged by other insurers for the same coverage. If an insurer charges more than its competitors, few people will buy its policies and it could go out of business. (Competitiveness is similar to reasonableness in that they both relate to what consumers consider a “good price.” However, there is a difference: a price is reasonable if it is a good price in terms of the benefits it buys; a price is competitive if it is a good price compared to the prices of similar products offered by others.)

• Equity: Some insureds make more claims than others, and consequently the cost of providing coverage is different for different insureds. The premium amount each insured pays must reflect the expected cost of providing coverage to that insured. Why? Suppose an insurer charged some insureds less than the expected cost of providing coverage to them. That insurer would have to charge other insureds an extra amount to make up for those paying less than cost. Those insureds paying extra would go to other insurers that would not charge them extra. The original insurer would be left only with insureds paying less than costs and could go out of business. (Of course, it is impossible to predict precisely what the cost of providing coverage to any insured will be, and consequently premium amounts cannot exactly reflect actual costs, but insurers must strive for equity to the extent possible.)

The Components of a Premium Amount

The principle of adequacy requires that a premium amount be sufficient to cover costs and provide a profit. The amount of a premium is based on the estimated amounts of different kinds of costs, plus profit. Thus, profit and the main types of costs can be thought of as components that added together make up the necessary amount of a premium. The cost components are:

• claims (benefit payments);

• reserves (to cover outstanding and future benefit payments);

• margin (an amount included to cover an unexpectedly large amount of benefit payments); and

• expenses (operational and administrative costs).

Another component is investment income, the revenue that insurers derive from investing the premium payments they receive. Investment income is not added but rather subtracted from the necessary amount of a premium, since it is not a cost that the premium must cover but rather a financial gain that partially offsets the need for premium payments.