You have insurance, but do you understand it?
In this article, we’ll be tackling the question, “How does insurance work?”
You have insurance. You might even have an insurance agent. But how does insurance work, exactly?
In this article, we’ll be looking under the hood of the insurance industry to show you how the process works.
What is Insurance?
An insurance policy is a financial contract between an insurer (the party issuing the policy, usually an insurance company) and the policyholder (the individual or business entity purchasing the policy).
According to this contract, the insurer agrees to pay the policyholder a certain amount of money to compensate for a loss that is specified within the contract. In return, the policyholder agrees to pay the insurer a certain amount of money every month (or year) for the duration of the contract.
There are many types of insurance and just about anything can be insured (at varying coverage levels), provided you can find an insurance carrier who is willing to issue you a policy.
Every insurance policy is different—even those issued by the same company. This is why it’s so important to understand the details about your specific policy: what is covered, what is excluded, and what your limits are.
How Does Insurance Work?
Here’s a very simplified explanation to give you an idea of how insurance works. (If you’ve watched our recent video on The History of Insurance, this will be familiar to you.)
Let’s say that you and nine of your friends just purchased brand-new smartphones. As you’re comparing and admiring the various features, you all start to express concern that something will happen to your expensive new gadget. You’ve already purchased protective cases and screen protectors, but you’d love to have an additional layer of financial protection.
So you and your friends come up with a plan: each of you puts $50 into an envelope. Since there’s 10 of you, you’ve now collected $500…the “brand-new phone” fund. If any of you destroys your phone sometime within the next year, s/he can take the money to buy a new one.
$50 is a drop in the bucket compared to the $500 you could potentially lose if you break your phone, so each of you are more than willing to risk “losing” that money for the reassurance that you won’t have to shell out the full five Benjamins later.
That’s the basic level of how insurance works.
That $50 is like your insurance premium and your friends are the other policyholders that buy insurance through that company. You all have pooled your money together to create a fund that the insurance company will use to pay back any covered losses.
How Insurance Premiums Work
So what happens at the end of the year?
Let’s say you managed to take good care of your iPhone. By the end of the year, there isn’t a scratch on it. Dave, on the other hand, wasn’t so careful. He bought the cheapest case he could and tossed it around so much that he had to deplete the fund to replace his phone.
Overall, this system worked well for you all, so you decide to implement your “money-in-the-envelope” plan again next year. Only now, you have a bit more information to work with. You know who was careful with their phone (you) and who exposed their phone to more risk (Dave).
As a result, you might decide that people who purchased a certain type of phone case should contribute only $40, while Dave (due to his history of iPhone carelessness) will have to contribute $75.
Insurance companies have a similar (albeit more sophisticated) system in place. They employ underwriters to look over your information, determine your level of risk exposure, and (if they decide to issue you a policy) calculate your premium amount.
This system ensures that—while everyone is sharing some of the risk—those who are likely to deplete the “envelope” more quickly will also be responsible for putting more money into it.
How Do Deductibles Work?
Now let’s take our analogy up a notch and learn about how deductibles work.
Let’s say that Dave (after dropping his phone on the pavement one too many times) decides to cash in on that insurance policy and file a claim.
You and your friends have a lot of foresight and didn’t want people intentionally spiking their phones on the ground whenever they wanted a brand-new phone. So you developed a rule: if you want to use the $500 to purchase a new phone, fine. But you have to pay the first $100 of whatever the phone costs before you’re allowed to touch the money in the envelope.
In the insurance world, this is called a deductible. Dave’s deductible is $100. Your car insurance deductible might be $1,000.
In many cases, your deductible is inversely related to your premium. This means that a high-deductible policy might come with a slightly lower premium. If you’d rather have a lower deductible, you might have to pay a bit more premium.
How Do Insurance Companies Make Money?
You might be thinking, “Wait a minute…policyholders must file thousands of claims a day. How do the insurance companies make any money if they’re always paying out on claims?”
Trust us when we say that insurance companies won’t stay in business if they’re not making any money! Overall, there are two ways that insurance companies make a profit.
The first way is a business model that relies on taking in more money than they’re paying out. They count on correctly guessing what they need to charge as well as the type and number of claims people will file. If they guess incorrectly (and more money starts to go out than in), they may respond by raising premiums the following year to ensure they have enough.
The second way is by investing that pool of premiums (i.e. the money in the envelope) so they can earn interest on it. This helps ensure that there’s always money available when someone needs it.
So Who Gets the Better Deal?
The insurance company gets to have a thriving business that employs thousands of people. But policyholders get the peace of mind that comes from knowing future covered losses can be reimbursed.
And what’s more, there’s an easy way that families and business owners can make sure they’re getting the best value: by working with an independent insurance agent like Harry Levine Insurance.
Because they aren’t tied in to any specific insurance company, independent agents can shop the market to find coverage that best matches your expressed needs, goals, and budget.