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What Is Insurance and How Does It Work?

Fact-checked with HomeInsurance.com

We have no way of knowing when life will toss a wrench in our plans. All we can do is prepare. That’s where insurance comes in. 

Insurance is a safety net you put in place to be ready for any possibility. With home or renters insurance, you can make sure a catastrophe doesn’t derail you financially or rob you of life’s comforts. With car insurance, you can make sure you’re able to pick up the tab for any damage you cause on the road without having to dip into your savings. Basically, people buy insurance policies to make sure that if life’s what-ifs become what-nows, they’re prepared financially. 

What is insurance?

When you buy an insurance policy, you pay your insurer a set amount of money called a premium. It’s the purchase price for the protection your insurer provides. Then, if anything happens that your policy covers, your insurer pays you the money you need to recover from the situation (up to your policy limits). 

Let’s take auto insurance as an example. Say you cause a fender-bender. Without insurance, you’re on the hook for not only repairing your own front bumper, but also for paying to fix any damage to the car you ran into. On top of that, if the driver in that car says you gave them whiplash, you can be held liable for their medical bills. It can all add up fast. 

With a car insurance policy in place that covers property damage, bodily injury and collision damage, you don’t have to pay for any of these things alone. Your policy picks up the tab. That’s an oversimplification (we’ll talk about things like deductibles and policy limits later), but it gives you a general idea of how your policy can help you. 

Insurers are willing to pick up the tab for these one-time, big-ticket expenses because they’re happy to take the money from your premiums every year. With your premiums, you keep their business afloat. With the coverage you get in return, you can make sure an unexpected incident doesn’t sink you. 

How does insurance work?

Insurance is a give-and-take between you and your insurer. The more risk they take on for you, the more you’ll have to pay them. 

For example, most states require drivers to at least have property damage and bodily injury liability insurance. These cover damages you cause to other people’s property and injuries  if you hurt someone on the road. 

What about your own car? If you want protection to repair your car after an accident, you’ll need collision coverage. Because your insurer is taking on more risk by agreeing to protect your car against more unknowns, you’ll pay more. Want to protect your car against theft? You’ll need comprehensive coverage, and you’ll pay more for that too. 

The more coverage you choose, the higher the premiums you’ll pay to your insurer in exchange for their willingness to cover your risk. 

What is an insurance premium?

We’ve mentioned the term “premium” a couple of times. This is the fee you pay to your insurer per policy term in exchange for your coverage. As we explained earlier, your premium depends (in part) on the amount of risk your insurer is protecting you against. More coverage means a higher insurance premium. 

Your coverage amount is not the only way insurers determine how much to charge you for your policy. They use a variety of factors to determine how risky you are to insure. If you’re buying home insurance, for example, providers will look at things like the crime level in your neighborhood, the age of your home and safety features you have. 

At the same time, insurance companies need to make a profit. If they think they can get your business by offering you a lower premium than their competitor, they may reduce premiums to entice you. 

Ultimately, insurance companies rely on internal experts like actuaries and underwriters to determine all of the various risks they have to consider before they write a policy for you. The insurance premium they charge you is based on how risky they perceive you to be, alongside a handful of other factors. 

What factors affect your insurance premiums?

You’re not the insurance company’s only client. Even if you don’t file a claim for three years, the provider still has other clients filing claims. That means they need more money to pay those people, which can mean a premium increase for you. For example, after wildfires swept through California, residents saw a jump in their homeowners insurance costs. 

You can’t control all of the factors that go into your insurance premiums, but you can make some strides toward scoring the most affordable coverage possible. 

To lower your premium, look for ways to lower your risk. Things like a history of safe driving or parking your car in a garage overnight can reduce the cost of your auto insurance, for example. Adding fire detecting and anti-theft features at your home can lower the cost of your home insurance coverage. Talk with your insurance company about the discounts it offers. Many of the discounts will be contingent upon things you can do to mitigate risk for your insurer. 

Remember the basics

Some factors that affect your insurance premium are out of your hands, but you can still do certain things to lower the cost of your coverage. Ask your insurance provider for a complete list of discounts it offers to see where you can take action to lower your premiums. 

What is a deductible?

While it would be great if your premiums were enough to enact your insurance policy when you need it, there’s usually one more step to get your insurer to pick up the tab. You need to pay your deductible. 

Your insurance deductible is an amount of money you pay to help cover an insured loss. The amount of your deductible is stipulated in your policy. It’s usually a flat dollar amount (e.g., $500 or $1,000), but some home insurance policies have a percentage-based deductible.

Some policies have deductibles that apply to the entire policy. Your health insurance usually works this way. If you have a $1,000 deductible, you pay toward it through your policy period until you eventually hit it, at which point your insurance starts covering costs.

Most home and auto insurance policies work with a per-claim deductible, though. If you have a $500 deductible for your car insurance, for example, you’ll need to pay $500 every time you get into a collision and want to repair your car.

Usually, you won’t have to write your insurer a check for this amount. Instead, it will send you money for your claim, subtracting the amount of your deductible from the total. So, if a vandal does $2,500 worth of damage to your home and you have a $1,000 deductible, your provider will pay you $1,500. If the damage doesn’t exceed your deductible (say, your new bumper costs $475 and your deductible if $500), you’ll have to pay the cost yourself in full. 

Why, then, doesn’t everybody choose the lowest deductible possible? The lower your deductible, the greater the cost (i.e., risk) for your insurer, which means you pay more for your coverage. Conversely, if you’re looking for a way to reduce the cost of your insurance policy, you can choose a higher deductible. Just make sure it’s an amount you can comfortably pay out-of-pocket. 

However, you may not always have to pay your deductible. Most policies won’t make you pay a deductible for liability coverage to kick in. Read your policy to understand when you do and don’t have to worry about covering this part of the expense of a covered loss.

What is a policy limit?

Insurance isn’t a catch-all for any financial woes that arise. It does go a long way toward helping you avoid serious financial burden after an unexpected issue, but it has its limits. 

When you buy insurance, your policy comes with limits on each coverage you buy. For example, most home insurance providers will put a cap on how much they will pay out for items like electronics and art. Basically, it’s your policy’s maximum benefit.

Most insurance policies come with different types of coverage, and those coverages have their own limits. Review your policy to make sure you have enough protection in each area. Also, make sure your limits don’t exceed what you need. For example, you don’t need $100,000 in personal property coverage with your home or renters insurance if it would cost only half of that to replace your belongings. The higher your policy limits are, the higher your insurance premium will be. 

How to file a claim

How does your insurance company know it needs to write you a check? You alert it to a covered loss by filing a claim. When you buy your policy, ask your insurer about the claims filing process because it varies from company to company. Some insurers allow you to submit a claim form online, while others require you to call an agent. 

To file your claim, you’ll need evidence surrounding the covered loss and its cause. If it’s a car accident, for example, you need pictures of the damage, the contact and insurance information of everyone involved and, when the damage is severe, a police report. For a home insurance claim, you’ll want pictures of the damage, proof of what was damaged and how much it was worth (a home inventory can come in handy here). For more evidence about your claim, your insurance company might send an adjuster out to appraise any damage.

Work with the adjuster to provide all requested information and stay in the loop as your claim moves through their filing process. Staying informed and involved gives you the best shot at getting your claim processed quickly and getting the highest payment possible from your insurer.

The takeaway

How does insurance work? 

  • You pay your insurer a set amount of money (your insurance premium) per policy term in exchange for your coverage.
  • When an incident that your coverage protects against arises, you file a claim to notify your insurer.
  • Your insurer then appraises the situation and pays you to cover your losses, up to your policy limits and, when applicable, minus your deductible.

Insurance can protect you financially if disaster strikes and can even be required by your state or your lender. By getting an insurance plan that covers your needs, you can get more peace of mind.

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