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What is insurance and how does it work?

Fact-checked with HomeInsurance.com

Insurance provides financial protection in the event of an unforeseen tragedy. Two of the most popular types of insurance are homeowners and auto insurance. In return for your premium payment, you can file a claim and be reimbursed for damages or loss incurred to vehicle or dwelling. 

The exchange of payment over time is a bet against risk, protecting yourself financially in the event you experience significant damages or loss to your home or automobile. Find out everything you need to know about how home and auto insurance, and what to expect from your coverage in this article.

What is insurance?

Insurance makes it more affordable to pay for damage to big ticket items like your home or car. More people paying premiums to an insurance company distributes risk since most damaging events occur randomly. When you make a claim, funds come from the pool of money that everyone has paid into. 

There are many instances in which getting insurance coverage is mandatory. For example, most states legally require you to have auto insurance. In some places, you may only need to get liability insurance to meet the minimum requirements to drive, but in others you may need a more comprehensive policy.

Homeowners insurance isn’t technically required if you own your home in full. But if you take out a mortgage, your lender will most likely require you to get a policy to ensure the investment is protected. Depending on where the home is located, you may also have to get additional policies, such as flood or earthquake insurance. 

How does insurance work?

You can explore a variety of types of policy to fit your needs. The price you pay depends on many factors, like how much coverage you receive and how risky the circumstances are. When reviewing your insurance policy, verify with your insurer to see what is covered and what is not. 

In the event of a loss, your insurer reimburses you for the cost to repair the damage. However, first the deductible will be subtracted from the repair cost. The deductible is the amount you’re responsible to pay before receiving any compensation from the insurance company.

The higher the risk you represent to the insurer, the more expensive your policy will be. For example, a home on the coast is more prone to flooding or hurricane damage. Consequently, you can expect to pay more for coverage.

Establishing your level of coverage

It’s important to determine the right amount of coverage to make sure you don’t pay more or less than necessary on your insurance policy. Make sure your policy meets the basic requirements, whether from your lender or state laws. Then evaluate your personal situation, like the value of your home or the outstanding loan balance on your car, to choose an appropriate policy value. 

Effect coverage has on deductible and premiums

The size of your deductible directly impacts the price of your premium. The lower deductible you’ll pay, the higher your premium will be because the insurance company will have to pay more when you file a claim. If your goal is to save money on your insurance premium, consider opting for a higher deductible. 

What is an insurance premium?

As you hear the term used often when discussing insurance, you may be wondering, “what is a premium?” An insurance premium is your payment to the insurance company for the policy. It can be charged annually, semi-annually or even monthly, depending on the provider. 

When you have homeowners insurance and a mortgage, your lender typically spreads out the annual cost into each of your monthly payments and holds the money in an escrow account. The lender will then pay the premium on your behalf before it is due. Auto premium payments are usually your responsibility to set up and manage.

Factors that determine your premium

There are a number of variables that can impact how much you pay for your premium. Here are the most common examples. 

  • Type of coverage: How much coverage you get has a large impact on your premium. The more comprehensive your policy, the more you’ll have to pay. 
  • Amount of coverage: Another factor is the value of the property you’re covering. A brand new car, for example, requires a larger insurance policy than one that’s 10 years old — so your premium will be more. 
  • Your personal information and circumstances: Insurance companies look at things like your credit report and your history of previous claims to determine the level of risk associated with your policy. A low credit score or lots of insurance claims in the past can make your premium jump. 
  • Competition in the insurance industry: A crowded insurance market in your area could also help you snag a lower premium, whether over the short-term or permanently. 

All of these factors are a part of a risk assessment that determines your insurance premium. An actuary is an industry professional who analyzes a range of factors to determine the risk involved with a specific policy.  

What factors affect your insurance premiums?

Other common factors also cause insurance premiums to fluctuate, including:

  • Driving record (auto)
  • Age and gender (auto)
  • Claims
  • Location

Here are some tips to get the lowest insurance premium given your personal situation.

Shop around

Comparing insurance quotes is extremely important. Look at the price of the premium as well as the amount of coverage you get to make sure you’re getting good value without overpaying.

Bundle policies

Insurance companies often offer a loyalty discount. If you need more than one type of insurance, consider getting both policies from the same company.

Ask for other discounts

You may be able to save based on other factors as well. Ask about discounts for things like being a senior, a military service member or certain upgrades to your home or car like a security system.

What is a deductible?

As mentioned earlier, a deductible is the amount of the loss you have to pay for as the policy holder. You may have a deductible that applies per-policy or per-claim. For instance, you may have to wait until you reach your deductible during a one-year period or for one single event. It’s more common to file for each claim with homeowners and auto insurance. Hurricane coverage, on the other hand, often has a deductible for the entire storm season

When you opt for a higher deductible, you’ll pay less for your premium. On the flip side, your premium goes up when you have a lower deductible since the insurer is obligated to cover a higher percentage of your claim when you file. 

What is a policy limit?

A policy limit is the maximum amount your insurance company will pay for a loss. Because you may have different types of coverage for different things in one policy, you may have separate limits for each one. Here are some common policy limits by the type of coverage.

Auto Insurance

  • Liability coverage: $100,000
  • Comprehensive coverage $300,000
  • Collision coverage $100,000

Homeowners Insurance

  • Dwelling coverage: between 50-75%
  • Other structures: usually 10%
  • Personal property coverage: Set by you
  • Liability coverage: Varies by provider

The size of your policy limit impacts the price of your premium just like your deductible does. If your policy limit covers a lower value amount, your premium will be lower because the insurer won’t have to pay out as much. Similarly, the higher your policy limit, the higher your premium will be as well. 

How to file a claim

A claim involves filing a policy event with the insurance company in order to get reimbursed for repairs or replacement due to damage or loss. Once you follow your insurer’s protocol for filing a claim (whether online, over the phone, or on paper), they’ll send out an insurance adjuster to assess the damage. If the claim is for your damaged car, you may have to take it to an approved mechanic. Once your claim is approved, you’ll be reimbursed for the approved amount, after subtracting your deductible from the total payout.

Here are some more details on what to expect when filing an insurance claim.

Open a claim

Assuming all parties involved are safe from harm (due to accident or storm, depending on the claim type), your first step is to contact your insurance company to notify them of the event. Likely you will be asked to describe the situation that took place, and answer a few other basic questions to assess the extent of damage and determine next steps. 

Estimate the damage

Get an estimate of the damage from the insurance adjuster, or for auto claims, you may be asked to submit photos of your dwelling, or have a mechanic provide an assessment, in order to determine the full extent of necessary repairs.

Gather documentation

Provide any required documentation, such as photos (from your damaged home or the site of a car accident) or receipts from any expenses you incur. The more documentation you have, the likelier you are to be fully reimbursed for expenses or repairs. 

Receive payment

Once the adjuster finishes the investigation, you should receive a payment, provided the damage is found to be a covered event.

Confirm completed work to release depreciation

If your homeowners insurance company includes recoverable depreciation, you may receive reimbursement in two parts: first, the initial actual cash value for required repairs, then a second reimbursement for the remaining value, once the work is completed. A certificate of completion from your contractor is typically used to verify completion of repairs.

The takeaway

  • An insurance premium is how much you pay for your policy.
  • The deductible is how much you must cover before getting reimbursed for a claim.
  • Many factors influence your premium, but some can cause your rate to fluctuate.
  • The claims process is similar for both home and auto claims, but payouts may differ.

Getting the right kind of insurance for your home and vehicle is a crucial part of your financial strategy. Although it’s an ongoing expense, the right policy protects you when an unexpected event occurs that would otherwise leave you in a financial emergency.

Lauren Ward

Lauren Ward is a writer for Coverage.com. She specializes in all things personal finance, including insurance, loans, and real estate.

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