Insurance: Everything you need to know

Insurance: Definition, how it works, what are its types

Disasters and accidents strike when they are least expected – and for people who lack the financial fallback to cushion against these unforeseen events, insurance can play a vital role in protecting the assets they worked hard for and the people they care for the most.

But insurance comes in different forms, and the key to finding the policy that fits one’s needs is understanding the type and level of coverage each one provides. In this article, Insurance Business explains everything there is to know about this essential financial instrument, so that your customers and potential clients can be armed with the proper knowledge to choose the best coverage possible.

This is part of our client education series, and we encourage insurance agents and brokers to share this article with customers to help them navigate this crucial financial tool.

What is insurance?

Insurance serves as a financial cushion in the event something bad happens to the insured person – also referred to as the policyholder – and their assets.

Merriam-Webster defines insurance as a form of “coverage by contract whereby one party undertakes to indemnify or guarantee another against loss by a specified contingency or peril.”

In layman’s terms, insurance is a written contract between a person and the insurance company that puts the responsibility of paying for losses that the insured incurs on the insurer. This is given that the incident is specified as a covered event and the policyholder meets regular payments.

In the event a fire destroys a house, for example, home insurance will cover for the costs to repair and rebuild the property. If a person causes a vehicular accident, meanwhile, auto insurance can pay out for medical bills and third-party property damage resulting from the collision. If a policyholder dies, their loved ones can receive a financial benefit through their life insurance plan.

But what’s paradoxical about insurance is that people are paying for something that they are hoping they would never use. Skipping coverage, however, risks putting them and their family in dire financial straits should an unfortunate event occur.

How does insurance work?

How insurance works varies significantly, depending on the policy and insurance provider. Regardless, all policies come with four main components that policyholders need to be aware of to ensure that they are getting the right coverage. These are:

• Premium: How much they need to pay for coverage.
• Policy term: How long the policy lasts.
• Policy limit: The maximum amount the policy will pay out for a covered peril.
• Deductible: The amount the policyholder needs to pay out of pocket before the policy kicks in.

What is an insurance premium and how is it calculated?

When purchasing an insurance policy, the first step a person needs to take is to apply and get approved. As part of this process, insurers evaluate how much risk they bring – meaning the likelihood that they will make a claim. From this, insurance providers calculate how much policyholders need to pay for coverage. This amount is called the premium.

Several factors come into play when determining premiums:

• Auto insurance rates, for instance, factor in the motorist’s age, gender, and driving history, among others.
• Home insurance premiums may be influenced by weather- and climate-related events in an area such as wildfires, hurricanes, earthquake, and flooding.
• Life insurance costs can go up or down, depending on a person’s medical history or smoking status.

Once approved, the policyholder will need to make payments regularly. Insurers often give the insureds the option to pay on a monthly, quarterly, semi-annual, or a yearly basis. It is crucial that they meet regular premium payments as failure to do so may affect their eligibility come renewal time or even void their coverage.

Read more: Insurance premium: What is it and how does it work?

What is a policy term?

Once the policy is active, it will remain in-force for a set period, called the policy term. At the end of the term, policyholders usually have two choices:

• Renew the policy with their current insurance provider
• Purchase a new one from another insurance company

Many policyholders also use the second option to get cheaper rates, but that’s not the only way to save on auto insurance premiums, among other insurance types.

If they experience a covered event during the policy term, they will need to file a claim to notify the insurance company about what happened and provide documentation as proof. The insurer will then investigate to determine the validity of the claim, and if it is, the provider will pay out for the losses. We will discuss the insurance claims process more deeply in a separate article.

How does a policy limit work?

The policy limit of an insurance plan refers to the maximum amount the insurer will pay out for specific claims. It is often listed on the policy document’s declaration page, which outlines the key details of the insurance contract.

There are several types of policy limits. These include:

• Per-occurrence limit: The maximum amount the insurance company will pay for a single event or claim.
• Per-person limit: The maximum amount the insurance provider will pay for a single person’s claims.
• Combined limit: A single limit that applies to several coverage types.
• Aggregate limit: The total amount that can be paid out for all claims during a set period.
• Split limit: A combination of per-occurrence, per-person, and aggregate limits.
• Special limits: The maximum amount an insurer will cover for special items under an insurance policy, including expensive jewelry, artwork, or collectibles under homeowners’ insurance, or classic or vintage cars under an auto insurance policy.

In some policies, policyholders are allowed to choose a limit. Others follow the requirements imposed by the government or an industry body. These include uninsured or underinsured motorist coverage in several states in the US.

Higher maximums also result in more expensive premiums. If a claim exceeds the policy limit, the insured may have to cover the additional expenses on their own.

What is a deductible and how does it work?

A deductible is the amount that the policyholder must shoulder before the insurance company pays out a claim. Depending on the type of policy, deductibles can apply per policy or per claim.

Insurers typically impose deductibles to avoid having to reimburse a barrage of small and low-value claims. Policies with high deductibles often have lower premiums. Some industry insiders also suggest policyholders choose higher deductibles to save on insurance costs but cautioned that the amount must be set at a level that they can afford to pay.

What are the most common types of insurance?

Individuals and businesses searching for some form of financial protection can choose from a diverse range of insurance policies, with each catering to different clients’ unique set of coverage needs. This section details what the most popular types of insurance available in the market cover.

Auto insurance

To operate a vehicle, it is almost always mandatory to carry car insurance. Getting caught driving without one can result in hefty fines and affect future eligibility for obtaining coverage.

Auto insurance is designed to protect motorists against financial losses in the event of accidents or theft. It does so by providing the following coverages:

• Bodily injury liability: Covers injuries the driver causes another person and legal fees if they are sued over the accident.
• Property damage liability: Pays out if a vehicle damages another person’s property and legal defence costs incurred in a lawsuit. 
• Combined single limit (CSL) liability: Provides one overall limit for bodily injury and property damage claims against the policyholder rather than having two separate limits.
• Personal injury protection (PIP): Covers medical expenses for the driver and the passengers, resulting from accidents covered by the policy. In the US, PIP is required by law in no-fault insurance states.
• Collision insurance: Pays for damage to the vehicle in the event it hits or gets hit by another car or object.
• Comprehensive insurance: Provides coverage for damages to the vehicle resulting from fire, flood, theft, vandalism, and other covered perils.
• Uninsured motorist (UM) coverage: Pays out for injuries the driver and their passengers suffer if they are hit by an uninsured driver.
• Underinsured motorist (UIM) coverage: Covers medical expenses incurred when the driver or passengers of a vehicle are hit by someone whose policy is not enough to cover all the costs.

There are a number of factors which go into choosing which type of insurance is required, often coming down to legislation in different countries, and even in different provinces and states within those countries.

Home insurance

Home insurance, also referred to as homeowners’ insurance, is not required by the law. Most lenders, however, set it as a condition for taking out a mortgage. Homeowners’ insurance may work differently, depending on several factors, including where the house is located, but most offer the following coverages: 

• Property damage: Pays out for any physical damage or loss to the house and other structures within the property’s premises – such as sheds, garages, and fences – if this was caused by a covered peril, which can include fire, wind, hail, or vandalism.
• Personal property: Covers personal possessions such as clothing, smartphones, furniture, jewelry, and other household items that were damaged or lost due to specified perils.
• Liability: Pays out for lawsuits and other legal expenses stemming from injuries to other people while on the property or its premises.
• Loss of use: Covers hotel stays, restaurant meals, and other living expenses should the policyholder need to relocate elsewhere because the property is under repair and uninhabitable.
• Medical payments: Often grouped with liability, this coverage pays out for injuries sustained by guests while on the property, regardless of who is at fault.

Given that the home is often one of the biggest financial investments people have, it is wise to have some form of protection.

Health insurance

Health insurance policies are aimed at helping policyholders offset the costs of medical treatment by covering a portion of the professional and hospital fees incurred.

According to the US government’s health insurance exchange website HealthCare.gov, this type of coverage comes in several forms designed to meet the varying needs of the insured. These are:

• Exclusive Provider Organization (EPO): This is a managed care plan where services are covered only if the doctors, specialists, or hospitals are in the plan’s network – except in cases of emergency.
• Health Maintenance Organization (HMO): This type of health insurance plan often limits coverage to care from doctors who work for or are contracted with the HMO.
• Point of Service (POS): In this kind of plan, policyholders pay less if they access doctors, hospitals, and other healthcare providers belonging to the plan’s network.
• Preferred Provider Organization (PPO): This health plan allows policyholders to pay less for healthcare if they choose to get treatment from providers in the plan’s network. However, they can also access doctors, hospitals, and providers outside of the network without a referral for an additional cost.

Health insurance plans are also offered in four categories based on how the costs are split between the policyholder and the insurer. These are Bronze, Silver, Gold, and Platinum, which are also referred to as the “metal tiers.” Here’s how the costs are split, according to HealthCare.gov.

The example above is for the American healthcare system. Many countries have different types of coverages that are part of a single payer healthcare system, or universal coverage, depending on where you live. Your health insurance needs can vary widely depending on your country.

Read more: A guide to finding the best affordable health insurance plan

Life insurance

Often confused with health insurance, life insurance plans provide a tax-free lump-sum payment to the policyholder’s family after they die. Coverage comes in different types but generally falls into two categories, with each type offering different levels of protection. These are:

Term life insurance

This type of policy covers the insured for a set term. It pays out a stated amount, called a death benefit, if the policyholder dies within a specified period. This means they can only access the payment in the years that the plan is active. Once the term expires, the insured has three options:

• Renew the policy for another term
• Convert the policy to permanent coverage
• Terminate the life insurance plan

Permanent life insurance

Unlike term life insurance, a permanent policy does not expire. Coverage is available in two main types, which combine the death benefit with a savings component.

• Whole life insurance: This offers coverage for the entire lifetime of the insured and the savings can grow at a guaranteed rate.
• Universal life insurance: This uses different premium structures, with earnings based on how the market performs.

A life insurance policy covers almost all types of death, including those due to natural and accidental causes, suicide, and homicide. Most policies, however, include a suicide clause, which voids the coverage if the policyholder dies by suicide within a specific period, usually two years after the start of the policy date.

An interesting aspect of life insurance you may not be aware of, is its ability to both protect and build your wealth. It is a much more useful form of insurance than most people realize.

What are the benefits of taking out insurance?

By now, it should be clear how important insurance is in protecting people and businesses financially. Having the proper coverage can help policyholders recover faster from unforeseen accidents and calamities by providing the monetary means to rebuild their lives. But one of the biggest benefits of taking out insurance is having the peace of mind of knowing no matter what happens, you are financially protected.

Do you still have questions? Be sure to get in contact with the insurance broker who sent this article to you, or refer to our Best of Insurance awards for help.

How about you? Do you think insurance is an important financial instrument? Use the comment section below to share your thoughts.