What is insurance?
Insurance is a contract between an individual (the policyholder) and an insurance company. This contract provides that the insurance company will cover some portion of a policyholder’s loss as long as the policyholder meets certain conditions stipulated in the insurance contract. The policyholder pays a premium to obtain insurance coverage. If the policyholder experiences a loss covered by insurance, such as a car accident or a house fire, the policyholder files a claim for reimbursement with the insurance company. The policyholder will pay a deductible to cover part of the loss, and the insurance company will pay the rest.
How Insurance Works
For example, suppose you have a homeowners insurance policy. You pay $1,000 per year in premiums for a policy with a face value of $200,000, which is what the insurance company estimates it would cost to completely rebuild your house in the event of a total loss. One day – as has happened to too many people in recent years – a huge wildfire envelops your neighborhood and your house burns to the ground. You file a claim for $200,000 with your insurance company. The company approves the claim. You pay your $1,000 deductible, and the insurance company covers the remaining $199,000 of your loss. You then take that money and use it to hire contractors to rebuild your house.
When you buy an insurance policy, you’re pooling your loss risk with the loss risk of everyone else who has purchased insurance from the same company. If you get your homeowners insurance from State Farm, which sells far more homeowners insurance policies than any of its competitors, you’re joining forces with millions of other homeowners to collectively protect each other against loss. Each homeowner pays annual premiums; State Farm collected more than $39.593 billion in earned premiums in 2016, according to its annual report.
Only a small percentage of homeowners will experience losses each year – 5.3% of insured homeowners filed a claim in 2014, for example. And most of those losses will be relatively small; the average homeowners insurance claim was for $11,402 in 2015, which is more than most people could comfortably pay out of pocket on their own, but far from a worst-case scenario. Further, the average homeowner only files a claim once every 9 or 10 years. Insurance companies are therefore able to use the premiums from homeowners who don’t file a claim in a given year to pay for the losses of homeowners who do file a claim, which is called risk pooling. (For background reading, see The History of Insurance in America.)
What Should You Insure?
It only makes sense to purchase insurance to cover significant losses you can’t easily afford on your own. Few drivers who are found at fault in a major car accident can afford to pay tens of thousands of dollars in someone else’s medical bills, so they carry auto insurance that provides for medical payments to others. We have health insurance because if we get an expensive illness like cancer, insurance is the only way we’d be able to pay for our treatment.
It doesn’t make sense to purchase insurance where the cost of coverage is so high that you’ll likely end up paying for your entire potential loss in premiums whether you experience that loss or not. Nor does insurance make sense when you can comfortably afford to cover the loss yourself, which is why experts generally advise against insurance policies or extended warranties for basic consumer electronics like smartphones and televisions. (For more insight, see 15 Insurance Policies You Don’t Need.)
Insurance is available to provide financial protection against a wide variety of losses:
auto body damage from a car accident
medical payments to occupants injured in a car accident
death of someone on whom others rely for financial or caretaking support
emergency room visits
a lawsuit brought by a visitor who slips and falls on your icy front porch
help with basic activities of daily living
and many more.
When you carry the right types of insurance in the right amounts, you’ll be protected against potentially catastrophic losses that could send your life veering off course and devastate your finances.
In the next section, we’ll explain a few more fundamentals of insurance: the different types of risk and how to manage them, what an insurable interest is and why you need it, how to buy insurance and how insurance underwriting works.