What is Insurance?

Everything You Need to Know About Insurance

Insurance can minimize your financial liability in the case of a catastrophe and give you peace of mind.
When shopping for insurance, it is important to assess your individual needs to determine what insurance(s) you will actually require.

The world is a dangerous and risky place. Various catastrophes can befall an individual, and we as a species survived thanks to pooled resources and knowledge – after all, the explosion of technology in the past century finds its foundations on previous work. A magnificent concept would be a mechanism to mitigate risk in some kind of pool, spreading the risk among participants, so no single party is left to carry a burden single-handedly. That mechanism is insurance.

Note: I use liabilities in two ways in this article. The first is financial liabilities, which are simply financial obligations. The other is legal liability, as in at-fault responsibility

The Purpose and Function of Insurance

Insurance is not meant as an ATM or piggy bank to store wealth until it is needed. In fact, most people would hope to never need to claim insurance benefits, because the most common precipitator of benefits claims is some sort of disaster, whether personal or more far-reaching. There are many purposes of insurance, but the predominant one is to avoid catastrophic financial liability in the future – and thereby ensuring peace of mind.

Legal Requirements and Protection Against Financial Liability

Some types of insurance, such as auto and workman's compensation (for businesses), are required by the law. This regulation ensures anyone harmed by another's actions does not further suffer from the liable party's lack of assets. If someone maims you in a car accident because they were negligent, the legal requirement of auto insurance guarantees you do not suffer secondary or tertiary consequences from lack of assets on the liable party's side. Your medical costs will be covered, regardless of you or the liable party's financial assets. A similar idea mandates workman's compensation and other insurances.

Financial liability minimization is a prime motivator. Malpractice, auto, and professional insurances are designed to protect individuals or businesses whose actions may cause harm to someone else. Since harm can lead to judgments exceeding an individual or business's assets, insurance sets an upper limit on losses in the case of judgment against the insurance holder.

Protection Against Financial Ruin

Even if you are not liable for any wrongdoing, you may fall victim to circumstances and require protection. Another very common purpose of insurance is to negate the possibility of financial ruin. Auto insurance fits this category for the party at-fault. Disaster, health, and business insurances also fall under this purpose. Meeting litigation judgments or re-establishing yourself after a disaster are two important reasons to carry insurance.

Insurance intended for personal possessions, such as fire and renter's insurance, gives peace of mind to the beneficiaries because they know there is not certain bankruptcy in the future if the unlikely scenario of a disaster plays out. Not carrying insurance, especially for critical aspects like health and most people's largest asset (their home and vehicle), can lead to an insurmountable financial problem from a single moment of destruction.

Policy Basics: Common Terminology and Mechanisms

As stated above, the main reason to carry insurance is to mitigate financial liability. This is done by spreading the risk among several participants in similar-risk pools, which then may or may not trigger payouts. Insurance is not meant to provide steady wealth, and indeed the amount paid into an insurance plan will likely be more than the payout.

Risk-Spreading Mechanism

As an example, consider a pool of homeowner insurance participants. Every month, the insured pay a premium into a pool, which is the source of the benefit money. If one participant's house burns down, the insurance company allocates some of the assets in the pool to that participant. Most participants never receive any money, because they have no legitimate claim (i.e., their house is never destroyed). Hence all participants paid indirectly for one participant's house, but they all enjoyed the benefit of coverage in the case that a disaster befell them. Hence risk is spread among all.

This mechanism can and does break down. During disasters when many claims are made, an insurance company's assets could conceivably fall short of the legitimate benefits expectations. A famous example is AIG during the credit crisis in 2008 – claims against policies held by the company overwhelmed the company and it collapsed. To avoid this kind of failure, insurance companies are required to have minimum statutory reserves.

Calculation

Premium and limits calculations are made by the underwriter, who accepts financial liability on your behalf. The underwriter considers many factors relevant to the type of insurance. Actuaries use statistics and mathematical models to determine your rates and settlement.

Statistics and probability are a major part of the calculation. If you feel you are overpaying, remember that insurance policies are usually based on pools and assumptions. Other companies may treat your situation as less risky and hence offer you a lower premium or better terms (limits, deductibles, coverage periods). Make sure to shop around if you think you can get a lower rate.

Common Terms

Like all industries, there is a set of important terms used to describe complex subjects. Here are a few terms you should be familiar with:

Premium – periodic payment by insured to insurer to cover future claims
Deductible – amount the insured must pay before the insurer pays out
Lifetime Limit – upper limit the insurer is required to pay over the policy lifetime
Annual Limit – similar to lifetime, except per year
Liability Limit – upper limit per claim
Annuity – yearly payment (usually a settlement) which spreads a full benefit out over time.
Underwriter – company or person (the insurer) who accepts liability for a risk, thereby transferring risk from the insured to the insurer
Collateral – an asset that is considered at-risk if someone fails to meet financial obligations (defaulting on a mortgage puts the house (the collateral) at risk of being repossessed)
Structured Settlement – often an annuity, but not always; this is a benefits payment scheme over time
Rider/Endorsement – a specific change to a basic policy, intended for somewhat common deviations or to customize a policy to a particular insured
Surcharge – extra cost added to basic premium, usually due to at-fault claims or legal action (a traffic violation often results in a surcharge, which can be added in the middle of a policy period)
Actuary – person who determines rates and settlements for an insurance company based on statistics and mathematical models
Adjustor – person who assesses the extent of damage in an incident, which is used as the basis for the settlement offer

Different branches of insurance also have different terms depending on the branch. "Liability only" and "bodily injury" make sense for auto insurance, but it doesn't make as much sense for deposit insurance.

Types of Insurance

There are plenty of types of insurance. I have outlined the most common, some less well-known but still important, and some of the stranger insurance policies available. Remember insurance is meant to mitigate risk by pooling assets for several participants.

Consumer

Health – there are myriad health insurances
Life – paid out to survivors of the insured
Long-Term Care – for long-term medical care needs
Auto – all sorts of vehicles, and it is usually mandated by law
Homeowners - often does not cover "acts of God" / disasters
Renters – for personal belongings, not the building
Disability – covers part of your income for a period of time if you are unable to work
Recreational Vehicle – vehicle-specific insurance policies include coverage for boats, off-road vehicles, motor homes, trailers, etc.
Disaster – disaster-specific insurance policies include coverage for tornados, floods, earthquakes, etc.
Pet – for your loveable furry family members
Travel – for occurrences that happen before and during travel, such as having to cancel your trip or paying for medical care
Special Event – may cover cancellation costs and protect against liability at events such as a wedding, anniversary party, engagement party, retirement party, etc.
Identity Theft – for costs associated with recovery and restoration after identity theft
Kidnap and Ransom – for travelers and those working in dangerous areas, as well as those with high assets
Deposit – such as the FDIC, which automatically protects most depositors at banks

Business and Professional

Malpractice – doctors and other professionals whose expertise is their job
Errors and Omissions – for advice and service providing professionals (accountants, lawyers, etc.) to limit negligence claims liabilities; also known as Professional Liability Insurance
Workers Compensation – to protect businesses when they must pay injured employees
Landlord – to cover problems with a rented building
Casualty – for employee deaths or deaths caused by business operations
Ransom and Kidnap – for employees
Data Loss – more and more relevant insurance meant to protect companies from financial losses due to loss of data, either malicious or accidental
Auto – for fleets
Multiple Peril – bundles several common insurances together to ease the payment process (ex., employee health, casualty, and ransom insurance plus auto and building)
Crop – used by farmers to protect against financial ruin if crops are destroyed

Some other types of "insurance" are not termed insurance but act like insurance. These are derivative-based financial agreements, such as Credit Default Swaps (CDSs), which played a major role in AIG's downfall. They are still widely traded, and for insurance companies, there is an incentive to customize policies for large corporations. This is the securitization of risk.

Timing – When to Purchase and When to Reconsider

Insurance is intended to mitigate financial risks. However, insurance is not always necessary. There are insurance policies for so many possible problems and many of them simply are not relevant to all people or entities.

Some of the most important insurances regard life. Health and life insurance are practical and are much cheaper to purchase when the insured is far from needing them. Insurance is a business of probabilities, and a young, healthy, boring individual is much less likely to make a claim on health or life insurance in the near future. Conversely, a customer who is 95, smoked and drank all his/her life, and still enjoys skydiving once a week is much more likely to claim health or life insurance benefits. Timing is essential when purchasing insurance.

Other insurances, like auto, are only required when one owns or uses a car. If you plan to live in a major city with excellent public transit, your auto insurance is irrelevant (rentals usually have their own insurance attached). Purchase only what you expect to need, and there is little reason to purchase a plan that extends beyond that.

Entering into a policy early will affect lower premiums, but one must be careful not to discount the time value of money or possible life changes. Furthermore, applying earlier is better. Waiting can result in delays or denial, especially if a condition develops too much.

Remember, insurance is meant to mitigate future financial risks, and thereby it may ensure other important benefits, such as preventative medical care or income to purchase food after a major accident at work. Plenty of material is available online, and it may even prove overwhelming. Hopefully, we helped simplify some things about insurance for you. If you are unsure about what insurance is right for you, there are professional insurance brokers who can offer some assistance in choosing the most appropriate plan for your needs.