What Is Insurance?

 What Is Insurance?

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 (https://www.investopedia.com/terms/c/cross-liability-coverage.asp) to make payments more affordable for the insured.

Insurance policies are used to hedge (https://www.investopedia.com/terms/h/hedge.asp) against the risk of financial losses, both big and small, that may result from damage to the insured or their property, or from liability for damage or injury caused to a third party.1

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

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 (https://www.investopedia.com/terms/c/credit-worthiness.asp).

For example, if you own several expensive automobiles and have a history of reckless driving, you will likely pay more for an auto policy than someone with a single midrange sedan and a perfect driving record. However, different insurers may charge different premiums for similar policies. So finding the price that is right for you requires some legwork.2

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 (https://www.investopedia.com/terms/l/lifeinsurance.asp), 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 (https://www.investopedia.com/articles/personal-finance/012716/how-highdeductible-health-plans-work.asp) 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 (https://www.investopedia.com/terms/o/outofpocket.asp) expense generally results in fewer small claims.