What Is Insurance?
Essentially, insurance is a contract, represented by a policy, between an individual or entity and an insurance company that is designed to provide financial protection from losses and to lower the cost of payments to the client.
In addition to protecting the insured from financial losses, insurance policies help protect others from damage or injury caused to them either directly or indirectly through the insured’s own property or by liability for other people’s losses.
How Insurance Works
It is possible for nearly anyone to become insured through an insurance company, and most people or businesses can find an insurance company that is willing to offer them coverage for a price.
Common personal insurance policies include 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.
KEY TAKEAWAYS
- Insurance is a contract (policy) in which an insurer indemnifies another against losses from specific contingencies or perils.
- There are many types of insurance policies. Life, health, homeowners, and auto are the most common forms of insurance.
- The core components that make up most insurance policies are the deductible, policy limit, and premium.
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.
In order to select the best policy for you or your family, it is important to pay attention to the three critical components of most insurance policies—the deductible, premium, and policy limit
There are also insurance policies available for very specific needs, such as kidnap and ransom (K&R), medical malpractice, and professional liability insurance, also known as errors and omissions insurance.
Insurance Policy Components
When choosing a policy, it is important to understand how insurance works.
A firm understanding of these concepts goes a long way in helping you choose the policy that best suits your needs.
For instance, whole life insurance may or may not be the right type of life insurance for you.
There are three components of any type of insurance (premium, policy limit, and deductible) that are crucial.
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.
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 mid-range 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.
Policy Limit
The policy limit is the maximum amount 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, the maximum amount 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 is a specific amount the policy-holder 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 expense generally results in fewer small claims.
Special Considerations
With regard to health insurance, people who have chronic health issues or need regular medical attention should look for policies with lower deductibles.
Though the annual premium is higher than a comparable policy with a higher deductible, less expensive access to medical care throughout the year may be worth the trade-off.
What Is an Insurance Premium?
An insurance premium is the amount of money an individual or business pays for an insurance policy.
Insurance premiums are paid for policies that cover healthcare, auto, home, and life insurance.
Once earned, the premium is income for the insurance company. It also represents a liability, as the insurer must provide coverage for claims being made against the policy.
Failure to pay the premium on the individual or the business may result in the cancellation of the policy.
KEY TAKEAWAYS
- An insurance premium is the amount of money an individual or business must pay for an insurance policy.
- Insurance premiums are paid for policies that cover healthcare, auto, home, and life insurance.
- Failure to pay the premium on the part of the individual or the business may result in the cancellation of the policy and a loss of coverage.
- Some premiums are paid quarterly, monthly, or semi-annually depending on the policy.
- Shopping around for insurance may help you find affordable premiums.
How Insurance Premium Works
When you sign up for an insurance policy, your insurer will charge you a premium. This is the amount you pay for the policy.
Policyholders may choose from several options for paying their insurance premiums.
Some insurers allow the policyholder to pay the insurance premium in installments—monthly or semi-annually—while others may require an upfront payment in full before any coverage starts.
The price of the premium depends on a variety of factors, including:
- The type of coverage
- Your age
- The area in which you live
- Any claims filed in the past
- Moral hazard and adverse selection
There may be additional charges payable to the insurer on top of the premium, including taxes or services fees.
Auto Insurance
For example, in an auto insurance policy, the likelihood of a claim being made against a teenage driver living in an urban area may be higher than a teenage driver in a suburban area.
In general, the greater the risk associated, the more expensive the insurance policy (and thus, the insurance premiums).
Life Insurance
In the case of a life insurance policy, the age at which you begin coverage will determine your premium amount, along with other risk factors (such as your current health).
The younger you are, the lower your premiums will generally be. Conversely, the older you get, the more you pay in premiums to your insurance company.
How Premiums Are Calculated
Insurance premiums may increase after the policy period ends. The insurer may increase the premium for claims made during the previous period if the risk associated with offering a particular type of insurance increases, or if the cost of providing coverage increases.
Insurance companies generally employ actuaries to determine risk levels and premium prices for a given insurance policy.
The emergence of sophisticated algorithms and artificial intelligence is fundamentally changing how insurance is priced and sold.
There is an active debate between those who say algorithms will replace human actuaries in the future and those who contend the increasing use of algorithms will require greater participation of human actuaries and send the profession to a “next level.”
Insurers use the premiums paid to them by their customers and policyholders to cover liabilities associated with the policies they underwrite.
They may also invest in the premium to generate higher returns.
This can offset some costs of providing insurance coverage and help an insurer keep its prices competitive.
While insurance companies may invest in assets with varying levels of liquidity and returns, they are required to maintain a certain level of liquidity at all times.
State insurance regulators set the number of liquid assets necessary to ensure insurers can pay claims.
Special Considerations
Most consumers find shopping around to be the best way to find the cheapest insurance premiums.
You may choose to shop around on your own with individual insurance companies. And if you are looking for quotes, it’s fairly easy to do this by yourself online.
For example, the Affordable Care Act (ACA) allows uninsured consumers to shop around for health insurance policies on the marketplace.
Upon logging in, the site requires some basic information such as your name, date of birth, address, and income, along with the personal information of anyone else in your household.
You can choose from several options available based on your home state—each with different premiums, deductibles, and copays—the policy coverage changes based on the amount you pay.
The other option is to try going through an insurance agent or broker. They tend to work with a number of different companies and can try to get you the best quote.
Many brokers can connect you to life, auto, home, and health insurance policies.
However, it’s important to remember that some of these brokers may be motivated by commissions.
What Do Insurers Do With the Premiums?
Insurers use the premiums paid to them by their customers and policyholders to cover liabilities associated with the policies they underwrite.
Some insurers invest in the premium to generate higher returns. By doing so, the companies can offset some costs of providing insurance coverage and help an insurer keep its prices competitive within the market.
Key Factors Affecting Insurance Premiums
Insurance premiums depend on a variety of factors including the type of coverage being purchased by the policyholder, the age of the policyholder, where the policyholder lives, the claim history of the policyholder, and moral hazard and adverse selection.
Insurance premiums may increase after the policy period ends, or if the risk associated with offering a particular type of insurance increases. It may also change if the amount of coverage changes.
What Is an Actuary?
An actuary assesses and manages the risks of financial investments, insurance policies, and other potentially risky ventures.
Actuaries assess particular situations financial risks, primarily using probability, economic theory, and computer science.
Most actuaries work at insurance companies, where their risk-management capabilities are particularly applicable in determining risk levels and premium prices for a given insurance policy.
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