What is Insurance and How It Works?

what is insurance
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Insurance is a buffer or protection against financial losses that occur from unforeseen events. Health, life, car, home, and travel insurance are the most common types on the market, and most people in the U.S. have at least one kind of insurance protecting them.

In fact, car insurance is required by law in the U.S. 

Insurance is a mechanism for financial protection against loss or damage to the insured, their property, or a third party. The policyholder pays a monthly premium to an insurance company, and in exchange, the company offers financial protection or reimbursement on the occurrence of certain events. 

The 'events' that qualify for financial reimbursement are usually outlined in the contract. In this article, we'll take a closer look at how insurance works and its various components.

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How Insurance Works

Insurance is a contract between an insurance company and a policyholder (someone who pays for insurance in exchange for protection). This contract specifies the terms under which the insurance company must reimburse the policyholder.

For example, in the case of a life insurance policy, the insurance company typically provides financial support to the family of the insured if the policyholder dies.

The conditions of death and the exact amount of financial support provided will be specified in the contract.  Another example would be health insurance, where the insurance company provides financial support to the policyholder in a medical emergency.

This support may be in the form of paying for the ambulance and hospital bills or paying for a specific medication. As with life insurance, the exact terms and conditions of the policy will be specified in the contract.

In short, insurance is a way to safeguard yourself, your loved ones, or your property so that if an unforeseen event occurs, there's a financial buffer to handle the expenses involved.

Cost of Insurance

Insurance companies don't provide this financial protection for free - the price of an insurance policy comes in the form of monthly payments known as premiums.

When you sign up for an insurance policy, the company assesses the kind of risk they are insuring you against and the likelihood of that risk occurring.

This helps them arrive at a premium amount you have to pay every month.  This amount will differ based on several factors, including:

  • The age of the person being insured (in case of medical or life insurance)
  • Medical history
  • The likelihood of the contingencies occurring 
  • The type of insurance selected

Let's take health insurance as an example. An older man (above fifty) with a history of diabetes or other health complications will most likely pay a higher premium than a healthy twenty-five-year-old with a steady income.

This disparity is because there is a higher chance of a medical emergency occurring in the former case.  As such, the insurance company is taking a higher risk by agreeing to provide him with financial cover.

Because of the higher risk component, the premium needs to be increased to offset the risk in case the policy is activated.

Components of an Insurance Policy 

You've already heard most of the terms related to insurance, but here's a more detailed look at the different components of an insurance policy.

  • Insurer: The insurer refers to the company or institution that provides the policy. Typically, insurance companies focus on specific policies and specialize in a few. These companies have different approaches based on the protection you're looking for. For example, a medical insurance company may offer various policies, including different ones for terminal illnesses and surgical procedures.
  • Insured: In most cases, the insured individual also happens to be the policyholder. However, depending on the cover you want, you can also insure a part of your property, a loved one, or a third party.
  • Premium: The premium is the price you pay to purchase an insurance policy. The entire amount is typically split into smaller monthly payments to reduce the load on the policyholder. As mentioned earlier, the premium will differ significantly depending on various factors.  
  • Policy Limit: All insurance policies have a maximum amount they will pay in case of any loss or damage. The policy limit safeguards the company from depleting its financial resources entirely. This limit differs based on the insurance policy you sign up for. Generally, a higher policy limit means a higher monthly premium.
  • Deductibles: A deductible refers to a specific amount the policyholder must pay upfront before the insurance company gives them the amount specified in the contract (claim). A deductible protects the insurance company by deterring policyholders from making wrongful claims.

Types of Insurance

There are many types of insurance, some with particular conditions mentioned in the contract. However, there are four common types of insurance most people purchase: 

  • Life Insurance: This is perhaps the most common type of insurance, where the policyholder specifies a beneficiary (or beneficiaries) in their life insurance policy. The insurer pays a certain sum of money to the beneficiaries upon the policyholder's death.
  • Car Insurance: Car insurance is a prerequisite to owning a car in most U.S. states and covers the owner in case of damage to their vehicle. The reimbursement may be for accidents, vandalism, or other conditions mentioned in the clause.
  • Home Insurance: Home insurance is similar to car insurance in that your property is protected in case of damage due to certain conditions mentioned in the policy. Depending on the policy, this can include the loss of possessions due to natural disasters or through theft.
  • Health Insurance: Health insurance protects the insured (or their beneficiaries) in case of specific medical emergencies. The conditions for claiming medical insurance will differ, and policyholders can choose insurance that suits their particular needs.

While there are other insurance policies, these are the most common, and most people have at least one or two in their name.

Summary

Insurance is an effective way to mitigate financial risk in the long run through reimbursement or by providing you with a cushion in case of sudden unforeseen expenses.

While the premium may seem an unnecessary expense (as the claim is contingent on certain events), it will save you loads of money in the long run. 

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