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How do car insurance companies set my rates?


If you’re a reader of Plutigo, then you are undoubtedly aware that we recommend seeking out a wide variety of car insurance quotes in order to find the best option for you. If you have followed this advice, it’s also likely that the process has left you at least slightly bewildered, as you have been quoted rather different amounts for the same coverage by different insurers.

How can it be that insurers don’t offer the same rates to each person? Your risk when you speak to Allstate hasn’t changed from a few minutes earlier when you just talked to State Farm, has it?

To understand the variability in prices, we must first remind ourselves of the general concept behind insurance, which fortunately isn’t too complicated. If you’re worried about some kind of loss (typically financial) that may or may not occur, in most cases you are willing to pay a small amount on a regular basis (your premium) in exchange for another entity (the insurance company) committing to paying for the loss if it does happen (paying out a claim.)

This makes logical sense. For example, you don’t want to have to write a check for the entire value of your house if it burns down and you need to rebuild it. Nor do you want to have to cover the entire cost of the potentially very large medical expenses that you or others might incur as a result of a car accident that you cause. So you transfer those risks to the insurance company, in exchange for paying your monthly premium. Now the insurance company is responsible for covering losses if the unfortunate event happens.

In theory, anyone could enter into an agreement to cover those risks for you in exchange for advance payments. However, the reason why you don’t buy insurance from a random stranger on a street corner is that you don’t want to pay the premium only to find out that when you need to file a claim, that stranger doesn’t have a large enough pot of money (or any pot of money) to hold up his end of the bargain.

Properly managed and regulated insurance companies can back up their promises much better because they are required to have a very large pot of money. Where does the money come from? It’s all the premiums you have paid, plus those of your many fellow customers. The company rests its fortunes on the principle that it’s highly unlikely all the houses they insure are going to burn down at the same time. (In fact, it’s actually pretty unlikely that YOUR house is going to burn down. But as we said, you probably don’t want to take that chance, because if it does happen, it could ruin you financially.)

If the pool of insured parties is large enough, then the insurance company should be taking in enough premiums to maintain a deep pool of money that allows it to pay out the few claims it receives. That’s if is doing its job by calculating its risks accurately, meaning it is accurately estimating the likelihood of each customer filing a claim, the expected value of that claim, and thus the premium it must charge each customer.

But not all customers are created equal

The true complexity in the insurance industry comes from the fact that each customer represents a unique level of risk, so they can’t all be charged the same premium. We understand this implicitly. Some people are more likely to have car accidents, so on average they are going to cost the insurance company more money in claims. Hence in theory, each customer’s unique risk level should be met by a unique premium that is perfectly tailored to that person.

In practice of course, this would be impossible, because insurers can’t possibly know absolutely everything about a person that affects his risk level. Instead insurers create a list of customer data (age, gender, marital status, education level, location, type of car, etc.) to evaluate in order to assign customers to a finite set of groups consisting of customers with similar risk levels. Different premiums are then assigned to each group. Hence you and your best friend, though you live in the same town and drive similar cars, may pay a very different price for Allstate car insurance. Though the company doesn’t come out and tell you, it has assigned the two of you to different groups with different risk levels. It could be that one of you has a number of speeding tickets, while the other has a spotless driving record.

The assignment of these risk levels and the subsequent pricing for different groups is where armies of mathematical experts called actuaries come into the picture. They work for insurance companies to create models they can plug your information into, allowing them to determine behind the scenes what group you fit into and then spit out a quote. These math whizzes are constantly testing different possible pieces of customer information to collect that might give more precise insight into the risk level a customer represents.

Each company has its own proprietary models, and though most of them use a lot of the same customer information, different models will weight different factors differently. It’s these differences in the mathematical models that you are experiencing when you get a car insurance quote from State Farm for $150 a month, five minutes after you were quoted $100 by Allstate, though your age, marital status, address, etc. hasn’t changed.

Indeed, the risk you represent hasn’t changed. But only a supreme being knows exactly what that level of risk is, and hence the exact premium you should be charged to compensate for the risk. In the world of mere mortals, each company’s assessment of your risk is just an estimate, and there are as many estimates as there are actuaries creating models of risk.

Even if you have no background or interest in advanced mathematical concepts, the general ideas we’ve laid out probably make reasonable sense to you. But that doesn’t change the fact that it can be rather frustrating when you get very different prices from the various companies you are soliciting quotes from.

The challenge doesn’t necessarily stem from the idea that different models are responsible for the difference. Instead it’s the fact that you can’t see those models, and yet they are having a major impact on your life and finances. It’s like having multiple Wizards of Oz hidden behind a row of curtains, with each telling you they are all-powerful and knowing as they shout orders at you that you have no choice but to obey. Unfortunately the orders are all different, in some cases they seem to be directly in conflict with one another, and most of them are orders to do things you’d really rather not do. Which Wizard do you trust?

Hopefully you see this is more of a philosophical question than a real one. In a sense it doesn’t really matter to you what geos into the models determining your insurance pricing fate. Unless you are going to start your own insurance company, which we assure you is not a small undertaking, you are stuck with what the companies offer you. And that’s where Plutigo’s advice can help.

We stress the importance of getting multiple quotes when searching for car insurance, specifically because this problem exists. In fact, you could consider it an opportunity as much as a problem. You may be getting quotes from a number of companies that are higher than you would like. Just know that if you persist and get quotes from a few more companies, you may hit upon one whose models rate your risk level significantly lower than the others, and you have found yourself a bargain.

You may not know exactly why that company rates you as lower risk, but given that you’re likely not an actuary, you don’t need to know why. The important thing is that if the company meets your needs in other areas like customer service, claims service, and financial strength, you have likely found yourself a better option for car insurance.

In today’s world with big data, artificial intelligence, and algorithms seemingly controlling our lives, it’s possible to feel pretty helpless. So much of our existence is dictated by invisible forces that we will never be privy to, and even if we were, most of don’t have the mathematical background to fully understand them.

At least when it comes to car insurance, rather than just throwing your hands in the air and giving up, you can take some of your power back by digging in and following Plutigo’s multiple quote framework. While the exact details of car insurance rates will never be perfectly clear to any of us, at least we have a strategy for doing everything in our power to pay the lowest rates possible. Happy searching.