In one form or another, we all own/buy insurance. Whether it’s auto, medical, liability, disability or life, insurance serves as an excellent risk-management and wealth preservation tool. Having the right kind of insurance is a critical component of any good financial plan. While most of us own insurance, many of us don’t understand what it is or how it works. In this tutorial, we’ll review the basics of insurance and how it works, then take you through the main types of insurance out there.
What Is Insurance?
Insurance is a form of risk management in which the insured transfers the cost of potential loss to another entity in exchange for monetary compensation known as the premium. Insurance allows individuals, businesses and other entities to protect themselves against significant potential losses and financial hardship at a reasonably affordable rate. We say “significant” because if the potential loss is small, then it doesn’t make sense to pay a premium to protect against the loss.
After all, you would not pay a monthly premium to protect against a $50 loss because this would not be considered a financial hardship for most. Insurance is appropriate when you want to protect against a significant monetary loss.
Take life insurance as an example. If you are the primary breadwinner in your home, the loss of income that your family would experience as a result of our premature death is considered a significant loss and hardship that you should protect them against. It would be very difficult for your family to replace your income, so the monthly premiums ensure that if you die, your income will be replaced by the insured amount.
The same principle applies to many other forms of insurance. If the potential loss will have a detrimental effect on the person or entity, insurance makes sense. (For more insight, see 15 Insurance Policies You Don’t Need.) Everyone that wants to protect themselves or someone else against financial hardship should consider insurance. This may include:
- Protecting family after one’s death from loss of income
- Covering contingent liabilities
- Protecting against the death of a key employee or person in your business
- Buying out a partner or co-shareholder after his or her death
- Protecting your business from business interruption and loss of income
- Protecting yourself against unforeseeable health expenses
- Ensuring debt repayment after death
- Protecting your home against theft, fire, flood and other hazards
- This is Protecting yourself against lawsuit
- Protecting yourself in the event of disability
- Protecting your car against theft or losses incurred because of accidents
Fundamentals Of Insurance
How does insurance work? Insurance works by pooling risk. What does this mean? It simply means that a large group of people who want to insure against a particular loss pay their premiums into what we will call the insurance bucket, or pool. Because the number of insured individuals is so large, insurance companies can use statistical analysis to project what their actual losses will be within the given class.
They know that not all insured individuals will suffer losses at the same time or at all. This allows the insurance companies to operate profitably and at the same time pay for claims that may arise. For instance, most people have auto insurance but only a few actually get into an accident. You pay for the probability of the loss and for the protection that you will be paid for losses in the event they occur.
Life is full of risks – some are preventable or can at least be minimized, some are avoidable and some are completely unforeseeable. What’s important to know about risk when thinking about insurance is the type of risk, the effect of that risk, the cost of the risk and what you can do to mitigate the risk. Let’s take the example of driving a car.
Type of risk: Bodily injury, total loss of vehicle, having to fix your car
The effect: Spending time in the hospital, having to rent a car and having to make car payments for a car that no longer exists
The costs: Can range from small to very large
Mitigating risk: Not driving at all (risk avoidance), becoming a safe driver (you still have to contend with other drivers), or transferring the risk to someone else (insurance)
Let’s explore this concept of risk management (or mitigation) principles a little deeper and look at how you may apply them. The basic risk management tools indicate that risks that could bring financial losses and whose severity cannot be reduced should be transferred. You should also consider the relationship between the cost of risk transfer and the value of transferring that risk.
Risk Control :
There are two ways that risks can be controlled. You can avoid the risk altogether, or you can choose to reduce your risk.
Risk Financing :
If you decide to retain your risk exposures, then you can either transfer that risk (ie. to an insurance company), or you retain that risk either voluntarily (ie. you identify and accept the risk) or involuntarily (you identify the risk, but no insurance is available).
Risk Sharing :
Finally, you may also decide to share risk. For example, a business owner may decide that while he is willing to assume the risk of a new venture, he may want to share the risk with other owners by incorporating his business.
So, back to our driving example. If you could get rid of the risk altogether, there would be no need for insurance. The only way this might happen in this case would be to avoid driving altogether. Also, if the cost of the loss or the effect of the loss is reasonable to you, then you may not need insurance.
For risks that involve a high severity of loss and a low frequency of loss, then risk transference (ie. insurance) is probably the most appropriate protection technique. Insurance is appropriate if the loss will cause you or your loved ones a significant financial loss or inconvenience. Do keep in mind that in some instances, you are required to purchase insurance (i.e. if operating a motor vehicle).
For risks that are of low loss severity but high loss frequency, the most suitable method is either retention or reduction because the cost to transfer (or insure) the risk might be costly. In other words, some damages are so inexpensive that it’s worth taking the risk of having to pay for them yourself, rather than forking extra money over to the insurance company each month.
The Risk Management Process
After you have determined that you would like to insure against a loss, the next step is to seek out insurance coverage. Here you have many options available to you but it’s always best to shop around. You can go directly to the insurer through an agent, who can bind the policy. The process of binding a policy is simply a written acknowledgment identifying the main components of your insurance contract.
It is intended to provide temporary insurance protection to the consumer pending a formal policy being issued by the insurance company. It should be noted that agents work exclusively for the insurance company. There are two types of agents:
- Captive Agents: Captive agents represent a single insurance company and are required to only do business with that one company.
- Independent Agent: Independent agents represent multiple companies and work on behalf of the client (not the insurance company) to find the most appropriate policy
Underwriting is the process of evaluating the risk to be insured. This is done by the insurer when determining how likely it is that the loss will occur, how much the loss could be and then using this information to determine how much you should pay to insure against the risk. The underwriting process will enable the insurer to determine what applicants meet their approval standards.
For example, an insurance company might only accept applicants that they estimate will have actual loss experiences that are comparable to the expected loss experience factored into the company’s premium fees. Depending on the type of insurance product you are buying, the underwriting process may examine your health records, driving history, insurable interest etc.
The concept of “insurable interest” stems from the idea that insurance is meant to protect and compensate for losses for an individual or individuals who may be adversely affected by a specific loss. Insurance is not meant to be a profit center for the policy’s beneficiary. People are considered to have an insurable interest on their lives, the life of their spouses (possibly domestic partners) and dependents. Business partners may also have an insurable interest on each other and businesses can have an insurable interest in the lives of their employees, especially any key employees.
The insurance contract is a legal document that spells out the coverage, features, conditions and limitations of an insurance policy. It is critical that you read the contract and ask questions if you don’t understand the coverage. You don’t want to pay for the insurance and then find out that what you thought was covered isn’t included.
Insurance terminology :
Bound: Once the insurance has been accepted and is in place, it is called “bound”. The process of being bound is called the binding process.
Insurer: A person or company that accepts the risk of loss and compensates the insured in the event of loss in exchange for a premium or payment. This is usually an insurance company.
The person or company transferring the risk of loss to a third party through a contractual agreement (insurance policy). This is the person or entity who will be compensated for loss by an insurer under the terms of the insurance contract.
Insurance Rider / Endorsement: An attachment to an insurance policy that alters the policy’s coverage or terms.
policy may be purchased to cover losses above the limit of an underlying policy or policies, such as homeowners and auto insurance. While it applies to losses over the dollar amount in the underlying policies, terms of coverage are sometimes broader than those of underlying policies.
In order to insure something or someone, the insured must provide proof that the loss will have a genuine economic impact in the event the loss occurs. Without an insurable interest, insurers will not cover the loss. It is worth noting that for property insurance policies, an insurable interest must exist during the underwriting process and at the time of loss. However, unlike with property insurance, with life insurance, an insurable interest must exist at the time of purchase only. Now that you have the basics of insurance, let’s discuss specific types of policies.