Cost increases hit us from all angles—at the grocery store check-out, at the repair shop and yes, at our broker’s office. It almost seems that our insurance increases every time we renew. Why is that? And is there anything that you can do to reduce your costs? To answer those questions, it’s helpful to first consider what we are buying when we purchase insurance, how insurance companies make their money, and factors that influence the cost of insurance.
Fundamentals of Insurance
Insurance has been described as the ‘business of managing risks and protecting assets.’ Fundamentally, the responsibility of protecting your assets from damage or loss is yours to assume. However, when you buy insurance you are asking the insurer to assume the responsibility to protect the financial value of your assets against a number of anticipated and unexpected risks. Should an asset be damaged, destroyed or stolen the insurer undertakes the responsibility to pay for its repair or replacement.
Over the years insurance companies have become better at establishing a ‘risk level’ for whatever asset is being insured. In turn, insurance premiums are based upon the risk level that they establish for a given asset. For example, the risk level for a home can be influenced by where it’s located, such as the region, city, or even postal code. Of course, there are many more variables that factor into the cost of a homeowner’s insurance policy, some of which we will discuss later.
A second insurance fundamental is that ‘the losses of the few are paid by the premiums of the many.’ In other words, as the insurer collects payments (premiums) from you and me, and hundreds of other clients, they calculate that when the home, car, or other property of one of their clients is damaged or destroyed, they will have collected enough money to pay for the damages. They also project or hope that at the end of each year they will still have some money left over, which represents their profit.
In this regard, the Insurance Bureau of Canada, in their 2009 report entitled, “Facts of the General Insurance Industry in Canada,” provides a helpful explanation on some of the factors that influence the cost of insurance. They explain that:
To establish premiums, insurance [companies] estimate the number and cost of current and future claims, and the amount of investment income that the insurance company may earn between the receipt of premiums and payment of claims. Insurers must predict their claims settlement expenses, overhead, commission payments or selling costs, provincial and federal taxes, and [then funds] . . . must be put aside to cope with catastrophes.
The Insurance Bureau of Canada then explains that insurance companies face a unique challenge, which helps explain why the cost of insurance premiums can and do go up and down. Unlike the prices of other goods and services . . . an insurance premium reflects the current value of the claims that a pool of policyholders can be expected to make in the future, as well as the costs of administering those potential claims. In most other businesses, the costs of producing and selling a product are known before the price is determined, but P&C insurance [property & casualty] is priced before the costs are known. Companies do not know ahead of time how much it may cost to repair a house or a car, nor do they know definitely that they will be called upon to do so.
Therefore, the difficulty of predicting the number and cost of current and future claims, as well as the unpredictability of profits from the financial markets, simply means that rate setting will never be an exact science, and that premiums will go up in some years and in other years they will go down.
What Drives Insurance Cost Increases?
Let’s now consider in a little more detail four factors that drive the price of insurance up. They are: 1) inflation, 2) construction costs, 3) climate change, 2) volatility of the financial markets.
Inflation. Each year inflation eats away at the buying power of our money. As a result, the operating costs of insurance companies increase. At the same time the cost of each claim rises due to inflation’s effect on reconstruction and other costs. According to the Bank of Canada, the Consumer Price Index inflation rate has averaged around 2 per cent each year over the past 20 years. So, generally speaking it is quite possible that there would have been a parallel increase in insurance costs over this same period.
Construction & Reconstruction Costs. Increases in construction costs are one of the biggest reasons why insurance premiums rise. Although construction labour costs may decrease in poor economies, this is not always the case. On the other hand, the cost of construction materials has seen a steady increase over the past 10 years. This means that the cost to repair damaged or destroyed property continues to increase. In turn, insurance companies are compelled to pay higher costs for the claims that they service.
A related issue is Insurance-to-Value (lTV). This is defined as: “the amount of insurance that is written on property is approximately equal to its value.” Under this principle, it is important to both the insurance company and you as the policyholder that the level of insurance coverage is balanced against the actual costs of reconstruction in the event that your home is damaged or destroyed.
ITV has become a hot issue because of the significant discrepancy that currently exists between the amount properties are insured for and the actual cost of reconstruction. The July, 2009 issue of Canadian Underwriter noted that according to some experts:
…about 80% of residential homes in Canada are undervalued by 27%—a figure that hasn’t changed since 1995. When you factor in commercial properties, 60% of which are underinsured by 40%, according to MSB, the result is Cdn$11 billion in lost premiums for the property and casualty insurance industry. That does not necessarily include building contents, which many argue are also woefully undervalued.
The imbalance between the insured value of homes and the actual cost to repair or rebuild them is best understood in the light of the 2003 Kelowna forest fires. Forest fires destroyed over 230 homes and it was the biggest test ever for the insurance industry with respect to insurance-to-value. It turned out that almost every home was underinsured with most by about 50% of their actual replacement values. All claims were paid in full under the “Guaranteed Replacement Cost” provision, which is found in typical homeowners’ policies, however it meant that insurance companies’ bottom line suffered a serious blow.
The gap between estimated values and actual reconstruction costs was further widened by the red hot construction market in BC, which pushed up reconstruction costs even further. (It should be noted that although real estate values declined in 2008, reconstruction costs did not follow suit. For example, due to the increase in oil prices in 2008, the price of asphalt shingles went up some 30%.)
All these factors have a cumulative effect forcing insurance companies to constantly play “catch-up” through rate increases.
Climate Change. Climate changes have contributed to the increase in frequency and severity of extreme weather events, such as forest fires, windstorms, heavy rains, quick thaws, etc. These events often translate into water and other damage to homes and property. As a result, there are more claims and in many cases the cost of each claim is higher.
For example, the summer of 2003, with its abnormally hot, dry weather, was the worst ever for forest fires in British Columbia. The Kelowna fires forced the evacuation of 26,000 people from 9,000 homes in one night alone. Some 230 homes burned to the ground. Damage and loss claims from this fire alone came to almost $200 million. More recently, the Wildfire Management Branch of the Ministry of Forests reported that between April 1, 2009 and October 15, 2009 there were over 3000 wildfires in British Columbia.
Do disasters in the rest of Canada or outside of Canada affect the cost of my insurance in British Columbia? Yes. One reason for this is the effect that globalization and corporate mergers within the insurance sector. Canada’s insurance market is one of the most international and dynamic in the world. Nearly two thirds of the Canadian P&C insurance industry is foreign-owned. This means that what happens elsewhere in Canada or in the US can affect insurance costs in BC.
For example, damage caused by Hurricane Katrina was limited to a few of the southern US states. However, some of the companies that sold insurance to homeowner’s in the region are multinationals; they also sell insurance in Canada. So, to cover their losses in Louisiana they may decide to raise their prices for insurance in Canada. The large companies that provide insurance to insurance companies (re-insurance companies) would also have suffered losses due to Hurricane Katrina. To cover their losses, they too increase re-insurance premiums. Once again, the insurance companies we buy from react by raising the prices of the premiums that they sell us.
The good news is that overall, the international nature of the insurance industry benefits consumers by increasing competition, permitting greater risk diversification, and allowing access to international sources of capital to underwrite risks here in Canada.
General Economic and Financial Market Volatility. Insurance companies rely heavily on revenues that are generated by investing their customers’ premiums. When their investment returns are strong, they can operate their business at a break-even level—or sometimes even at a small loss, because they are able to rely on the revenues generated by their investments to bring their operation into the black.
However, increased claims payouts has meant that insurers have had less money available to invest in the financial markets. Worse still, when the financial markets are seriously depressed insurers face significantly diminished returns on their investments. In the past 18 months for example, insurers lost 30% of their equity and this loss if further compounded by the extremely low interest rates. These realities have therefore, forced insurers to generate more income by way of the premiums that they charge their customers.
How Can I Reduce My Insurance Costs
We know we need insurance. We also know that we don’t want to spend any more than we have to on it. So, how can we be sure we are getting good value for the money we spend on it?
Getting the Right Fit at the Right Price
Let’s consider how to get good value for your insurance dollar. First of all, what is good value? Good value in this instance can be defined as:
- Obtaining adequate coverage of your assets
- Benefitting from a insurance broker’s expertise and advocacy
- Paying a competitive price
Adequate Coverage. Buying insurance should be balanced against your risk-comfort level. First, ask yourself, ‘Do I live in a high-risk area for earthquakes, freezing water pipes, or sewer back-up? Is theft or vandalism a big problem in my neighbourhood? What is the age and condition of my house? Is the possibility of something negative happening high, medium, or low? If my home was damaged in some way, or even destroyed, how much could I pay (or would I want to pay) out of my own pocket to repair or replace the damage. If the damage was significant, could I pay out of my own pocket, or might I face bankruptcy?
Once you answer these and other risk-related questions, you are then able to decide the level of protection that will provide sufficient coverage in the event of a loss. Your broker will be happy to assist you with this analysis.
Insurance Expertise and Advocacy. On the surface, it doesn’t seem to matter much where you buy your insurance or what coverage you have . . . until you file a claim. So the single most important factor that determines whether payment for your losses is adequate is to carefully select your insurance policy right from the start.
A finely tuned insurance policy that precisely meets your needs at the lowest possible cost . . . requires an insurance expert. They know the right questions to ask and they know the right answers. They will take whatever time is necessary to make sure you know your options and understand your choices so that you can make informed decisions. They also act as your advocate at claims time to ensure that you are fairly compensated for your losses and have access to the full measure of coverage to which you are entitled. This is a critically important way to get good value for your insurance money.
Competitive Pricing. Although the cost of your policy is an important factor from a budgetary point of view, it is also important to carefully weigh the value of each insurance option. There are risks to buying the least expensive insurance. If we skydive, do we really want to buy the cheapest parachute we can find? It’s inexpensive, but there is no guarantee that it will really protect us when we need it.
Insurance is for times of serious need. The payments might appear high or hurt a little now, but having it is a way to protect your future and it gives you peace of mind during the trip there. To spend a fixed amount each month to pay for your insurance will appear insignificant when your vehicle or home is replaced due to accident or fire. The sad reality is that those without insurance rarely recover from their losses.
At the same time, getting good value for your insurance dollar does not necessarily mean premiums will cost more. In fact, getting good value will often cost the same, while providing better coverage.
An apples-to-apples comparison of one policy against another policy is one of the most important ways to ensure you are getting adequate coverage at a competitive rate. To achieve this you need to do a comparison of the:
- Type of coverage being offered
- Level of payout for each type of coverage
- Deductibles and restrictions on each type of coverage
For example, suppose you bought your home insurance from Bob’s Insurance for the past 3 years. Each year they send you the renewal forms and the price has gone up by 10% each year. This year the premium is $895 for 12 months. This year, you decide to get a quote from Joe’s Insurance. At Joe’s Insurance they ask you if you have made any major upgrades to your home. You explain that you finished the basement and put in a rental suite. Joe’s Insurance crunches the numbers and their quote comes in at $1250 for 12 months.
Bob’s Insurance is offering better value, right? Well, it is less money, but it is not better value. What’s the problem? First of all it’s not an apples-to-apples comparison. Bob’s Insurance didn’t ask about upgrades. Had they known about the upgraded basement and the new suite their price would more than likely have been significantly higher. Here is the really scary part. Assume you renewed your policy with Bob’s Insurance and a little later you have a kitchen fire in the suite that damages much of the house. Because you didn’t inform the insurance company about the finished basement and the new suite, your entire policy could be voided and your claim denied all-together, or the payment for the damages would be significantly less than the actual cost to repair your home.
This scenario highlights the importance of dealing with an experienced insurance broker, and doing an apples-to-apples comparison of quotes. So, buy wisely. Carefully select a broker who can assist you to make well informed decisions. This will save you money now, and most importantly when you have to file a claim. Now that is good value! Please feel free to contact us for additional information on how to get great value and the most out of your insurance dollar.