An insurance premium is simply the amount of money you must pay to maintain insurance coverage. Premiums are typically billed monthly, quarterly, or annually. And in every case, the premium is paid before your coverage begins. Thus, a monthly car insurance premium paid in January will pay for coverage for February, for instance.

How insurance premiums work
Insurance premiums are primarily driven by risk. The higher the probability that something will happen, and the greater the loss if it does, the higher the premium will be. For example, young male drivers pay more for car insurance than older females because they are much more likely to 1) get in an accident and 2) do significantly more damage when they do.

This is a fundamental concept in understanding how your insurance premium works. The more frequently an insurer expects to pay out for losses, and the more severe it expects these losses to be, the higher your premium must be to compensate for the risk.

Ultimately, premiums are designed to cover a number of expenses, including:

  • Expected losses -- How much money can the insurer expect to actually pay out in losses on your policy?
  • The cost of processing claims -- Paperwork is costly to make, and even costlier to process.
  • Overhead expenses -- Advertising, corporate offices, and statisticians don't come cheap!
  • Fraud -- Yes, some people will burn down their home or throw their cell phone in a swimming pool for an insurance payout.
  • Profit -- No risk is taken for free.

All these costs are priced into your insurance premium, but the primary influence on any insurance premium is the expectation of losses. How risky, exactly, are you to insure?

Insurance premiums and the role of insurance
Insurance is designed to protect you from financial risks that you otherwise couldn't afford to pay for. We insure our homes from catastrophe, because few of us could afford to shell out $100,000 or more if it were to burn down while we're away at work. Likewise, we insure our cars because an accident can easily cost $10,000 or more, especially if it results in a trip to the emergency room.

However, that doesn't mean there aren't ways to cut corners. I would argue that many Americans are actually over insured. That is, many Americans are paying for insurance they don't necessarily need.

One of the most common traps in insurance is paying for small-dollar insurance. For example, your homeowner insurance policy might have a deductible of $0, which means your insurance will pay for losses beyond $0 per event, basically any and all losses.

If you're the kind of person who has emergency savings, you can probably get away with a higher deductible. After all, it doesn't make much sense to insure every single risk to your home if you can easily afford to pay for small-dollar losses out of your own pocket. A few misplaced roofing shingles after a thunderstorm isn't the kind of loss that will break the bank, so why insure yourself against it?

Likewise, it usually doesn't make much financial sense to buy small-dollar warranties on "big ticket" items like electronics, since a broken TV or smartphone might cost you a few hundred dollars at the most. In the grand scheme of things, a broken smartphone isn't exactly a financially ruinous event.

In almost every case, the smaller the risk you insure, the less benefit you can expect to receive as the insurer's overhead costs consume more of the premium. A great example is found in the difference between homeowners insurance and warranties. For every $1 customers pay for homeowners insurance, they receive about $0.65 back from losses. Product warranties -- some of the most profitable policies ever created by the insurance industry -- pay out about $0.20 in losses to customers for every $1 in premiums taken in.

Knowing this, it almost always makes more sense to self-insure (pay out of pocket) for small losses by choosing a higher deductible in exchange for a lower insurance premium. It's likely that if you simply bank the savings in your insurance premium, you'll find that what you save makes up for what you'll have to pay (the higher deductible) in the rare case of a financial loss.