Disasters and accidents strike when they are least expected – and for people who lack the financial fallback to cushion against these unforeseen events, insurance can play a vital role in protecting the assets they worked hard for and the people they care for the most.
But insurance comes in different forms, and the key to finding the policy that fits one’s needs is understanding the type and level of coverage each one provides. In this article, Insurance Business explains everything there is to know about this essential financial instrument, so that your customers and potential clients can be armed with the proper knowledge to choose the best coverage possible.
This is part of our client education series, and we encourage insurance agents and brokers to share this article with customers to help them navigate this crucial financial tool.
What is insurance?
Insurance serves as a financial cushion in the event something bad happens to the insured person – also referred to as the policyholder – and their assets.
Merriam-Webster defines insurance as a form of “coverage by contract whereby one party undertakes to indemnify or guarantee another against loss by a specified contingency or peril.”
In layman’s terms, insurance is a written contract between a person and the insurance company that puts the responsibility of paying for losses that the insured incurs on the insurer. This is given that the incident is specified as a covered event and the policyholder meets regular payments.
In the event a fire destroys a house, for example, home insurance will cover for the costs to repair and rebuild the property. If a person causes a vehicular accident, meanwhile, auto insurance can pay out for medical bills and third-party property damage resulting from the collision. If a policyholder dies, their loved ones can receive a financial benefit through their life insurance plan.
But what’s paradoxical about insurance is that people are paying for something that they are hoping they would never use. Skipping coverage, however, risks putting them and their family in dire financial straits should an unfortunate event occur.
How does insurance work?
How insurance works varies significantly, depending on the policy and insurance provider. Regardless, all policies come with four main components that policyholders need to be aware of to ensure that they are getting the right coverage. These are:
- Premium: How much they need to pay for coverage.
- Policy term: How long the policy lasts.
- Policy limit: The maximum amount the policy will pay out for a covered peril.
- Deductible: The amount the policyholder needs to pay out of pocket before the policy kicks in.
What is an insurance premium and how is it calculated?
When purchasing an insurance policy, the first step a person needs to take is to apply and get approved. As part of this process, insurers evaluate how much risk they bring – meaning the likelihood that they will make a claim. From this, insurance providers calculate how much policyholders need to pay for coverage. This amount is called the premium.
Several factors come into play when determining premiums:
- Auto insurance rates, for instance, factor in the motorist’s age, gender, and driving history, among others.
- Home insurance premiums may be influenced by weather- and climate-related events in an area such as wildfires, hurricanes, earthquake, and flooding.
- Life insurance costs can go up or down, depending on a person’s medical history or smoking status.
Once approved, the policyholder will need to make payments regularly. Insurers often give the insureds the option to pay on a monthly, quarterly, semi-annual, or a yearly basis. It is crucial that they meet regular premium payments as failure to do so may affect their eligibility come renewal time or even void their coverage.
Read more: Insurance premium: What is it and how does it work?
What is a policy term?
Once the policy is active, it will remain in-force for a set period, called the policy term. At the end of the term, policyholders usually have two choices:
- Renew the policy with their current insurance provider
- Purchase a new one from another insurance company
Many policyholders also use the second option to get cheaper rates, but that’s not the only way to save on auto insurance premiums, among other insurance types.
If they experience a covered event during the policy term, they will need to file a claim to notify the insurance company about what happened and provide documentation as proof. The insurer will then investigate to determine the validity of the claim, and if it is, the provider will pay out for the losses. We will discuss the insurance claims process more deeply in a separate article.
How does a policy limit work?
The policy limit of an insurance plan refers to the maximum amount the insurer will pay out for specific claims. It is often listed on the policy document’s declaration page, which outlines the key details of the insurance contract.