Demystifying the Law: How Does Insurance Work?

Posted August 5, 2010 in Demystifying the Law by

Most of us have insurance, in one form or another. If you drive a car, truck or motorcycle, you have auto insurance. If you work for a business of any size, you are covered under your employer’s worker’s compensation insurance and unemployment insurance. You may also have health insurance, life insurance, homeowner’s insurance or renter’s insurance.

Most of us understand insurance pays out when we make a claim, but many don’t understand the fundamentals of how insurance actually works.

Managing Risk

At its most basic level, insurance is about managing financial risk. We all face risks in life. You might get sick. Your home might be destroyed in a fire. Your car might be damaged in an auto accident. Any one of these events could be so expensive that it wipes out your savings, or costs more to fix than you can afford.

When you purchase insurance, you make an upfront payment (called a premium) to an insurance company. In turn, the insurance company agrees to pay for any claims you make in the event of an accident, injury or other incident. (Your claim, of course, must meet the strict parameters of your insurance policy. A homeowner’s policy, for example, typically wouldn’t pay an auto accident insurance claim.)

Types of Insurance

For almost any particular risk, there is an insurance company that is willing to insure it.

If you’ve ever attended a sporting event where the team offers $1 million to a spectator who makes a basket from half court or a hole in one golf shot, you might be surprised to learn that the team doesn’t pay that prize money out of its own pocket. Instead, an insurance company sells insurance that pays out if someone wins the prize. And every few years a rumor goes around about a singer who’s insured his voice or a model who’s insured a particular body part against injury.

The average person, however, will probably never purchase some of these specialized policies. More common types of insurance include:

  • Motor vehicle insurance, including insurance for cars, motorcycles, trucks, recreational vehicles and boats
  • Property insurance, including homeowner’s insurance, condo insurance and renter’s insurance as well as insurance that protects against specific types of events, such as hurricane insurance or flood insurance
  • Health insurance, including medical insurance and dental insurance
  • Life insurance
  • Excess insurance and umbrella insurance, which covers losses in excess of the coverage limits provided by your primary insurance policies

There are also specialized policies that some individuals should buy, depending on their life circumstances. These might include:

  • Insurance for specific life events, such as trip or travel insurance, disability insurance, wedding insurance or credit insurance
  • Other types of insurance policies related to home ownership, including title insurance and private mortgage insurance
  • Insurance to cover other valuables, such as pet insurance, art insurance, jewelry insurance or appliance insurance
  • Professional liability insurance, including medical malpractice insurance if you are a doctor or legal malpractice insurance if you are an attorney

How Insurers Make Money

The insurance company is, in a sense, gambling on the fact that while you are a customer, you will pay it more in premiums than it will pay to you in claims. If all of its customers collectively pay more in insurance premiums than the insurance company pays out in claims, then the insurance company makes a profit. If the insurer has a bad business year and pays more in claims than it collects in premiums, then insurance premiums will probably increase.

Setting Insurance Premiums

Insurers set their premiums based on the expected risk that a particular client presents. For example, automobile insurers know that a 17-year-old boy who has just received his driver’s license and is driving a sports car is more likely to get into an accident than a 50-year-old man in a sedan who has been driving accident-free for decades. Because the younger driver presents a higher risk, that driver pays a higher automobile insurance premium than the older driver.

The insurance companies look at many factors when deciding whether to issue an insurance policy to a prospective client and how much to charge that client in premiums. Among the factors the insurance company might consider:

  • Auto Insurance: A driver’s age, sex and driving record; the type of car; the car’s safety and anti-theft features; how many miles the car is driven each year; auto theft rates in the area; the customer’s desired deductible, or the portion of money that the customer is responsible for paying in the event of a claim
  • Health Insurance: A person’s age, sex and weight; whether a person is a smoker; whether a person has any chronic health problems; whether a person has any untreated medical issues; whether a person engages in any high-risk activities, such as riding a motorcycle; the desired deductible
  • Property Insurance: A home’s location and value; the value of the home’s contents; whether the home is located in an area prone to flooding, hurricanes or tornados; whether the home is located in a high-crime area; whether a home has smoke alarms, a burglar alarm and other security features; the desired deductible
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