Summary Explanation of How Insurance Works
An insurance policy is a financial contract between a policyholder and an insurer, which is almost always an insurance company. The insurer agrees to pay in the event that the person or property insured suffers a type of loss named in the policy. For example, an auto liability policy will pay for the damage sustained by another vehicle and any injuries to its occupants in an accident where you are at fault. A renters policy may pay for damage to your stereo as a result of a water leak in your apartment. The protection remains in force for a specified "policy term," typically six months or a year, after which you´ll need to renew the policy in order to continue the coverage.
Whatever the policy type, it will generally only pay for losses that are specifically named in the policy. Therefore, you should always read any insurance policy carefully before you purchase it.
In return for coverage, you pay the insurer a specified amount, called the "premium." Premiums are typically paid in monthly installments, but may also be paid all at once or in other intervals. Insurance companies use a process called "underwriting" to evaluate your risk factors and estimate the statistical likelihood that you´ll suffer a covered loss and file a claim. The higher a company determines your risk factors to be, the more it will charge in premium (as the company believes it is more likely that it will have to pay you). If your risk factors are too high, a company may decline to sell you a policy. Each insurance company uses its own underwriting formula for assessing risk factors. If one company turns you down, keep shopping; another company may be willing to cover you.
Almost all types of insurance policies have a "deductible." A deductible is an amount you must pay out of your own pocket before the policy will pay anything toward a covered loss. For example, assume you have an auto policy with a $1,000 deductible. If you have an accident that results in $5,000 in damages to your car, you´ll have to pay $1,000 toward the cost of your repairs. The insurance company will pay the remaining $4,000. You can normally choose the deductible you want. The higher your deductible, the lower your premium will be. Keep in mind, however, that if you have a high deductible, you´ll have to pay more if you have a claim. A high-deductible policy with a lower premium may seem like a good deal until you´re involved in an accident and have to pay the higher deductible all at once.
For some types of insurance, the insurer will pay a percentage of the cost of a claim, and you must pay the remaining amount. For instance, if you have surgery, an insurer might pay 80 percent of the cost of the surgery, leaving you to pay the remaining 20 percent. This cost sharing is called "coinsurance." Many health plans also have "copays." These are amounts you pay each time you receive a covered health service. You might have to pay a $20 copay each time you go to the doctor, for example.
Almost all insurance policies will have a "coverage limit." This is the maximum amount it will pay toward any covered loss, regardless of the actual costs you incur.
Many people pay insurance premiums for years and never file a claim. This can lead some people to think they´re wasting money and cause them to cancel their coverage. In the event they suffer a loss, however, they must pay the full cost themselves.
When you buy an insurance policy, you´re buying protection. You´re protected against unexpected financial losses, whether you ever actually use the coverage or not.
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Last updated: 10/07/2015