Most people have some kind of insurance: for their car, their house, or even their life. Yet most of us don’t stop to think too much about what insurance is or how it works.
Put simply, insurance is a contract, represented by a policy, in which a policyholder receives financial protection or reimbursement against losses from an insurance company. The company pools clients’ risks to make payments more affordable for the insured.
KEY TAKEAWAYS
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Insurance is a contract (policy) in which an insurer indemnifies another against losses from specific contingencies or perils.
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There are many types of insurance policies. Life, health, homeowners, and auto are the most common forms of insurance.
- The core components that make up most insurance policies are the deductible, policy limit, and premium.
How Insurance Works
A multitude of different types of insurance policies is available, and virtually any individual or business can find an insurance company willing to insure them—for a price. The most common types of personal insurance policies are auto, health, homeowners, and life. Most individuals in the United States have at least one of these types of insurance, and car insurance is required by law.
Businesses require special types of insurance policies that insure against specific types of risks faced by a particular business. For example, a fast-food restaurant needs a policy that covers damage or injury that occurs as a result of cooking with a deep fryer. An auto dealer is not subject to this type of risk but does require coverage for damage or injury that could occur during test drives.
To select the best policy for you or your family, it is important to pay attention to the three critical components of most insurance policies: deductible, premium, and policy limit.
There are also insurance policies available for very specific needs, such as kidnap and ransom (K&R), medical malpractice, and professional liability insurance, also known as errors and omissions insurance.
Insurance Policy Components
When choosing a policy, it is important to understand how insurance works.
A firm understanding of these concepts goes a long way in helping you choose the policy that best suits your needs. For instance, whole life insurance may or may not be the right type of life insurance for you. Three components of any type of insurance are crucial: premium, policy limit, and deductible.
Premium
A policy’s premium is its price, typically expressed as a monthly cost. The premium is determined by the insurer based on your or your business’s risk profile, which may include creditworthiness.
Policy Limit
The policy limit is the maximum amount that an insurer will pay under a policy for a covered loss. Maximums may be set per period (e.g., annual or policy term), per loss or injury, or over the life of the policy, also known as the lifetime maximum.
Typically, higher limits carry higher premiums. For a general life insurance policy, the maximum amount that the insurer will pay is referred to as the face value, which is the amount paid to a beneficiary upon the death of the insured.
Deductible
The deductible is a specific amount that the policyholder must pay out of pocket before the insurer pays a claim. Deductibles serve as deterrents to large volumes of small and insignificant claims.
Deductibles can apply per policy or per claim, depending on the insurer and the type of policy. Policies with very high deductibles are typically less expensive because the high out-of-pocket expense generally results in fewer small claims.
Types of Insurance
There are many different types of insurance. Let’s look at the most important.
Health Insurance
With regard to health insurance, people who have chronic health issues or need regular medical attention should look for policies with lower deductibles. Though the annual premium is higher than a comparable policy with a higher deductible, less expensive access to medical care throughout the year may be worth the tradeoff.
Home Insurance
Homeowners insurance (also known as home insurance) protects your home and possessions against damage or theft. Virtually all mortgage companies require borrowers to have insurance coverage for the full or fair value of a property (usually the purchase price) and won’t make a loan or finance a residential real estate transaction without proof of it.
Auto Insurance
Life Insurance
Life insurance is a contract between an insurer and a policy owner. A life insurance policy guarantees that the insurer pays a sum of money to named beneficiaries when the insured dies in exchange for the premiums paid by the policyholder during their lifetime.
Travel Insurance
What is insurance?
What are the four major types of insurance?
There are four types of insurance that most financial experts recommend everybody have: life, health, auto, and long-term disability.
Is insurance an asset?
Depending on the type of life insurance policy and how it is used, permanent life insurance can be considered a financial asset because of its ability to build cash value or be converted into cash. Simply put, most permanent life insurance policies have the ability to build cash value over time.
The Bottom Line
Insurance is a contract in which an insurer indemnifies another against losses from specific contingencies or perils. It helps to protect the insured person or their family against financial loss. There are many types of insurance policies. Life, health, homeowners, and auto are the most common forms of insurance.
Eduindex 
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