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Insurance is a contract, represented by a policy, in which an individual or entity receives financial protection or compensation for losses from the insurance company. The company aggregates customer risk to make payments within the reach of the insured.
Insurance policies are used to hedge the risk of financial losses, large and small, that may result from damage to the insured or his property, or from liability for damage or injury to a third party.
How does insurance work?
There are many different types of insurance policies available, and almost any individual or company can find an insurance company willing to insure them for a price. The most common types of personal insurance policies are auto insurance, health insurance, home insurance, and life insurance. Most individuals in the United States have at least one of these types of insurance, and car insurance is required by law.
KEY IMPORTANT ISSUES TO NOTE
- Insurance is a contract (policy) under which an insurance company compensates another company for losses arising from some emergency or risk. 1
- There are many types of insurance policies. The most common forms of insurance are life, health, homeowner and auto insurance
- The basic components that make up most insurance policies are deductibles, policy limit, and premiums.
Companies require special types of insurance policies that insure against certain types of risks that a particular company faces. 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. The auto dealer is not subject to this type of risk but does require coverage for damage or injury that may occur during a test drive.
There are also insurance policies available for very specific needs, such as kidnapping and ransom (K&R), medical malpractice, and professional liability insurance, also known as errors and omissions insurance.
Components of an insurance policy
When choosing a policy, it is important to understand how insurance works.
A solid understanding of these concepts goes a long way in helping you choose the policy that best suits your needs. For example, whole life insurance may or may not be the right type of life insurance for you. There are three components to any type of insurance (premium, policy limit, and deductible) that are crucial.
The policy premium is its price, usually expressed as a monthly cost. The premium is set by the insurance company based on your or your company’s risk profile, which may include creditworthiness.
For example, if you own many expensive cars and have a history of reckless driving, you will likely pay more for an auto insurance policy than someone with a mid-range sedan and a perfect driving record. However, different insurance companies may charge different premiums for similar policies. So finding the right price for you takes some effort.
The policy limit is the maximum amount an insurer will pay under an insurance policy for a covered loss. Limits can be set per term (eg an annual term or policy term), per loss or injury, or over the life of the policy, also known as a lifetime cap.
Higher limits usually carry higher premiums. For a general life insurance policy, the maximum amount that the insurer will pay is referred to as the face value, which is the amount paid to the beneficiary upon the death of the insured.
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The withholding/deductible is a specified amount that the policyholder must pay out of pocket before the insurance company pays a claim. Discounts are used as a deterrent to large volumes of small and insignificant claims.
Discounts can be applied per policy or per claim depending on the insurance company and policy type. Policies with very high deductibles usually cost less because higher out-of-pocket expenses generally result in fewer small claims.
In terms of health insurance, people who have chronic health problems or need regular medical care should look for policies with lower deductibles.
Although the annual premium is higher than a similar policy with a higher deductible, lower-cost access to Medicare throughout the year may be worth the trade-off.