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Basics of Insurance: How Does Insurance Work

Basics of Insurance: How Does Insurance Work - We all need insurance, but few of us really know how it works. In the simplest terms possible, here’s how insurance works: You and other policyholders pay premiums to an insurance company. 

Basics of Insurance: How Does Insurance Work

In return, the company agrees to pay for some portion of your losses if something bad happens. That’s it! Of course, things are a bit more complicated than that in practice, but that’s the basic idea behind insurance.

Basics of Insurance

It takes some effort to learn how insurance works, but it’s vital to understand the basics of coverage in order to get what you need. Awareness of what’s available and how it works can have a significant impact on the cost of insurance.

This article provides valuable information that will help you choose the right policies to protect your lifestyle, assets, and property.

Insurance is a very practical concept. If you can't afford to lose something and need help repairing the damage, insurance is a great solution. 

You pay a monthly fee and, in return, you have the peace of mind that comes with knowing your losses will be taken care of if something goes wrong.


  • Insurance premiums are payments made to an insurance company.
  • The purpose of insurance is to protect you from some risks in exchange for your premium payments. An insurance company agrees to pay you money if losses occur.
  • There are many types of insurance policies available, such as for cars, homes, lives, health, and disabilities.

What Is Personal Insurance?

Personal insurance is a type of policy that covers risks that you would not be able to afford on your own. This includes losses related to mishaps, illnesses, death, or damage to property you own.

How Does Insurance Work?

When you buy insurance, you make payments to the company. These payments are called "premiums." In exchange, you are covered from certain risks. The company agrees to pay you for losses if they occur. Insurance is a way to spread the risk of potential losses among many people.

The insurance company has a lot of clients. They all pay premiums. Not every client will have a loss at the same time. When a loss does happen, they may get insurance money to pay for the loss.

Not everyone needs to purchase insurance, but it is a good idea to do so when you have a lot of money at risk. However, when a bank has a financial interest in the property, like when they hold a mortgage, purchasing insurance is typically a condition for getting the loan approved.

Note: Some insurance policies have extra costs, while others, like auto insurance, may have minimum requirements set by law.

Why Does the Bank Require You to Be Insured?

Some insurance is not required by law. However, many lenders, banks, and mortgage companies will require it if you have borrowed money from them to make a purchase worth a lot of money, such as a house or car.

To buy a car or house, you'll need to have insurance on it. If you have a car loan, you'll need car insurance. If you have a home loan, you'll need home insurance.

A loan is often needed to finance large purchases like homes. Lenders want to make sure that you are covered against risks that may cause the car or home to decline in value if you were to suffer a loss before you have paid it off.

Getting a Good Price on Insurance

The premium is the price you pay to an insurance company for the coverage it provides. Premiums are usually charged monthly, every six months, or yearly.

To save on your premium, shop around with a few companies or use a broker. They can get you the best rates by comparing quotes for you. Rates will vary depending on how claims are handled and the company’s underwriting.

Note: If you let your car or home insurance lapse, your lender will put their own insurance on it and charge you for it. This is not a good idea because the lender's insurance is more expensive than the policy you would buy on your own.

Some insurance companies may offer discounts to entice specific types of customers. How well your profile matches the insurer's profile will determine how good your rate will be.

There are a variety of ways that insurers attract different types of clients. For example, if an insurer wants to target younger people, it may create programs with discounts for recent graduates or young families. 

Other insurers may focus on seniors or members of the military, offering bigger discounts in order to draw them in. It’s important to research and compare policies in order to find the best deal for you.

When Should You Buy Insurance?

There are a few reasons why you should buy it:

  1. You're legally obligated to have things like car insurance.
  2. It is a common requirement for a lender, such as when you buy a home or get a home insurance policy.
  3. If you have valuable belongings in your apartment, it’s important to have renters insurance. If something happened that resulted in a financial loss that you couldn’t afford to pay for or recover from easily, renters insurance would help. For example, if your computer equipment was damaged, renters insurance would help cover the costs.

The 5 Basic Types of Personal Insurance

There are a few different types of personal insurance that people usually think about when they hear the term. These five are some of the more common types, but there are certainly others.

  1. Residential, Residential insurance policies can provide coverage for your home, condo or co-op, and in some cases, coverage for your belongings even if you are renting. Make sure you are fully protected by getting the right type of policy for your needs.
  2. Motorcycle and car insurance are both essential to have. They offer coverage in case of an accident or damage to your vehicle.
  3. Boat insurance, There are two types of boat insurance: insurance that can be covered under home insurance in some circumstances, and stand-alone boat insurance for vessels that are not covered under home insurance. The type of coverage you need depends on the type of boat you have and how you use it.
  4. These are all types of insurance that can be very important in protecting your health, your life, and your ability to work. Make sure you are fully protected by researching your options and choosing the right plan for you.
  5. There are many types of liability insurance. It protects you if someone else experiences a loss that is your fault.

There are a variety of insurance policies available, but it's not guaranteed that you'll be able to find what you need from one company. Insurance is licensed and falls into different categories. 

This means that in order to sell it or provide you with advice, a company must be licensed by the state to sell and give advice on the specific type of insurance you're looking for.

Some companies may not offer life or disability insurance, but they may be able to refer you to an agent with the proper licensing.

Note: You could save money on your premiums by buying multiple policies from the same insurance company. Known as "bundling," this strategy can get you a discount on your rates.

What Does a Residential Policy Cover?

Home insurance protects your property. This includes the buildings on your property, such as your main dwelling and any other structures. 

It also covers the contents of your dwelling, like your furniture and belongings, and pays for temporary living expenses if you have to leave your home after a loss. Home insurance also provides liability protection in case someone gets injured on or near your property.

Renters insurance protects your belongings as well as living expenses if you have to leave your home temporarily due to a loss. It also covers personal liability in your home and in other parts of the world.

Condo or co-op insurance is similar to renters insurance. In addition to your personal property, living expenses, and liability, it also covers things that are specific to owning a unit or shares in a building. For example, it may help protect you from legal action if someone is injured on your property or if there is water damage in your building.

Note: It is important to always read the fine print of your insurance policy to make sure you are getting what you expect. Not all policies are the same, so it’s important to be an informed consumer.

Car, Boat, and Other Vehicle Insurance

There are a lot of options available when it comes to car, boat, and other vehicle insurance. The most basic type is liability insurance, which covers any legal responsibility you may have for owning or operating the vehicle or vessel. You can also get extra coverage for damage to the vehicle or vessel itself, as well as to its individual parts.

Medical costs and death benefits may be included as extra or mandatory features of car insurance, depending on state laws.

Health, Life, and Disability Insurance

Insurance policies like health, life, and disability insurance are designed to provide coverage if something happens that results in an illness, death, or a permanent disability. 

Long-term care insurance is a less common type of policy that can also help pay for health-related events that occur over a longer period of time.

There are many different types of health insurance policies. Some policies offer basic health benefits, while others may include dental or long-term care coverage. There is a policy to fit every need, so you can find the right coverage for you.

How to Read the Small Print in Insurance Policies

Your insurance declaration page lists and describes the basic limits of your coverages. The policy wording is the final word on how your insurance works in a claim.

Many people don't read the small print in their policy. That's why some people are confused and upset when they have a claim that doesn't seem to be going their way.

7 Insurance Policy Terms to Know

In your insurance policy, you will find some key phrases. It is important to know what they mean.

1. Deductible 

The deductible is the amount of money you will have to pay if you make a claim. If you choose a high deductible, you'll be taking on more risk, but your payments will be lower. Some people choose a high deductible as a way to save money.

2. Exclusions

Small print in insurance policies often contains exclusions, which are items that are not covered by the policy. Make sure to ask about exclusions when purchasing a policy, so you aren’t surprised by them if you ever have to file a claim.

3. Type of Policy

There are several types of policies offered by companies. If you get a low price on a policy, ask what type of coverage it is and what the limits are. Compare this information to the details in other quotes you have.

4. Special Limits

When deciding on a policy, it is important to be aware of the limits set in place. This is especially important when making a claim, as you need to know how much coverage you will be receiving. 

Ask your insurer about the specific coverages that have limits and what those limits are. If you are not comfortable with the limits shown in your policy, you can often ask for a policy that will offer you higher limits.

5. Waiting Periods and Special Clauses

When looking for insurance, it's important to be aware of any waiting periods or special clauses that could affect your coverage. For example, with dental insurance, there may be a waiting period before you're eligible for benefits. 

With life insurance, there may be a contestability period during which the insurance company can deny your claim. Make sure to ask about any waiting periods or special clauses that may apply to the policy you're considering buying.

6. Endorsements 

Endorsements are optional additions to a policy that can help increase the coverage it provides. However, in some cases they may also reduce or limit what is covered by the policy.

7. Basis of Claims Settlement

There are different ways that insurance companies can settle claims. You need to be aware of what these are so you can choose the best policy for you. 

Replacing something with the same thing is known as replacement cost. This is what most home insurance policies will do. Actual cash value means the company will replace an item with something that is worth the current market price, minus depreciation. This may not be what you want, so make sure you know what the basis of claims settlement is before you buy a policy.

How Do Insurance Companies Pay Claims?

When you experience a loss, such as a car crash or house fire, you should contact your insurance company right away. They will record your claim and look into it to find out what happened and how you are covered.

If you have a covered loss, the insurance company may send you a check for your loss minus your deductible. You will need to pay the deductible out of pocket.

Do You Get a Refund if You Don’t Make a Claim?

When you pay for insurance, you may start to wonder why you’ve been paying so much for so long without making a claim. Some people may feel like they should get their money back when they haven’t had a claim. That’s not how it works; your money goes towards future claims.

This is the concept of “shared risk”. The idea is that over time, less money will be paid out in claims than the total premiums collected. It may seem like you’re throwing money out the window if you never file a claim, but having peace of mind knowing you’re covered in case you do suffer a significant loss can be worth its weight in gold.

Premium vs. Claims Payments

This is an example to help you understand how premium and claims payments differ.

You’re paying $500 a year for home insurance, and you’ve made no claims in the 10 years you’ve been making payments. That comes out to $5,000 total. In the 11th year, you have a kitchen fire and the company pays you $50,000 to get your kitchen fixed. You start to wonder why you are paying so much for nothing.

If the insurance company gave everyone back their money when there was no claim, they would never be able to pay out on claims. For example, even if you paid them $5,000 over 10 years, it still wouldn’t cover your $50,000 loss.

If you experience a loss, the company becomes unprofitable. This is because insurance is based on spreading the risk among many people. The pooled money of all people paying for it allows the company to build assets and cover claims when they happen.

What Makes Insurance Rates Go up or Down?

Insurance is a business. Companies have to make sure they can cover all the potential claims their policyholders may make, so rates go up and down.

Rate increases and underwriting changes are based on the results insurance companies have seen in the past. When companies tally up how much they paid in claims at the end of the year vs. how much they got in premiums, they need to revise their rates in order to make money.

Noote: It depends on the company you buy your insurance from. If you get it from a captive agent, they'll only sell you insurance from one company. If you go through a broker, they'll offer insurance from many different companies.

What Are Agents, Captive Agents, and Insurance Brokers?

When purchasing insurance, you will likely interact with agents and brokers who work for the insurance company. They will explain the different types of products available.

A captive agent is someone who represents only one insurance company. They know all about that company’s products and services, but they can’t offer any insights about policies or pricing from competing companies.

An insurance broker or independent agent represents more than one company and must be familiar with the products offered by all of them. They can provide you with access to multiple companies so that you can find the best product for your needs.

How to Decide What Coverage You Need

There are a few key questions you can ask yourself to help you decide what kind of coverage you need.

  • How much money can you afford to lose on your own?
  • What would happen if you had an accident and couldn't work? Would you be able to cover your costs? What about if your home or car was destroyed?
  • Do you have the savings to cover you if you can’t work due to an accident or illness?
  • Higher deductibles can lead to lower premiums, but can you afford them?
  • Do you have special needs in your life that require extra coverage?
  • What concerns you most? Policies can be tailored to your needs and identify what you are most worried about protecting. This may help you narrow down the kind of policy you need and reduce your premiums.

When choosing a policy, it’s important to consider your current lifestyle and life stage. Some policies are better for young people who are just starting out, while others are more suited for those who are settled in their careers and have families.

Selecting the right insurance is important for managing your finances and remaining safe in case of a loss. The type of insurance you need depends on your life stage, assets, and goals. 

That’s why it’s important to talk to an agent about what you need and want from your policy. Having the right insurance products in place can give you peace of mind.


There are a lot of misconceptions about insurance. In this article, we are going to clear up some of the basics and explain how insurance works. We hope this information was helpful! If you have any further questions, please feel free to reach out to us. We would be happy to help.