Most individuals have insurance of some type, whether it is for their life, their home, or their car. However, the majority of us rarely pause to consider what insurance is or how it functions.
In a nutshell, insurance is a contract, symbolised by a policy, under which a policyholder receives financial security or compensation from an insurance firm against losses. In order to make payments to the insured more manageable, the company pools the risks of its clients.
Insurance policies are intended to protect against the possibility of monetary losses, large and little, that may be brought on by harm to the insured or their property or by liability for harm or injury given to a third party.
How Insurance Works
There are many different types of policies to choose from, and almost any individual or business can find an insurance company willing to insure them for a certain price. The most common types of personal insurance are auto, health, homeowners, and life insurance. In the United States, most people have at least one of these types of insurance, and auto insurance is required by law.
Businesses require specific types of insurance policies to insure specific types of risks faced by specific businesses. For example, a fast food restaurant needs a policy that covers damage or injury caused by cooking with a deep fryer. Car dealerships are not exposed to such risks, but do need to cover damage or injury that may occur during a test drive.
Components of an Insurance Policy
When choosing a policy, it’s important to understand how insurance works.
A solid understanding of these concepts will help you choose the policy that best suits your needs. For example, life insurance may or may not be the right type of life insurance for you. Three components of any type of insurance are critical: premiums, policy limits, and deductibles.
The premium for a policy is its price, usually expressed as a monthly cost. Premiums are set by the insurance company based on your risk profile or business, which may include creditworthiness.
For example, if you own several expensive cars and have a history of reckless driving, you may pay more for a car insurance policy than someone with a midsize sedan and a flawless driving record. However, different insurance companies may charge different premiums for similar policies. So finding the right price for you takes some effort.
The policy limit is the maximum amount an insurance company will pay for a covered loss under a policy. Maximum amounts, also known as lifetime caps, can be set per period (such as an annual or contract term), per loss or injury, or over the life of the policy.
Generally, higher limits lead to higher returns. For general life insurance, the maximum amount paid by the insurer is called the face value and is paid to the beneficiary upon the death of the insured.
The deductible is a certain amount the policyholder must pay out of pocket before the insurance company pays the claim. The deductible is designed to deter a large number of small and inconsequential claims.
Depending on the insurer and policy type, a deductible may apply to each policy or to each claim. Policies with high deductibles are usually cheaper because higher payouts usually result in fewer small claims.