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Insurance is an agreement between an individual (or a business) and an insurance company. Under this agreement, the insured pays premiums to the insurer in exchange for financial compensation in the event of a covered incident. For example, auto insurance could reimburse an insured driver for the cost of auto repairs (up to a limit) after an accident.

Also known as:indemnity, assurance, coverage

How does insurance work?

Insurance is a way of managing risk. Understanding basic risk management methods is a great way to decide if insurance is right for you. These are:

  • Avoidance - Not participating in an activity where damages may occur. For example, a way to keep from being in a car crash is to never get in a car.
  • Reduction - When you decide to reduce risk, you understand that the event in question may happen but take steps to minimize its possible occurrence. In this case, instead of never getting in a car, you commit to following all the rules of the road and not breaking any traffic laws. An accident may still happen, but you have taken measures to minimize the possibility of causing one.
  • Retention - When you retain the risk, you may or may not take measures to reduce it, but understand that the event in question may happen regardless of how you prepare and decide to deal with it if or when it happens. If someone who has decided to accept the risk of driving a car is in an accident, they may opt to simply pay for any repairs out of pocket.
  • Transference - When you understand that a given event may happen but don’t want to retain it and reducing it is insufficient, so you decide to transfer the risk to a willing third party. Insurance is an excellent example of risk transfer. Following the same example, you would pay a premium to an insurance company and it would pay up to a certain amount to repair your car in the event of an accident.

A core concept of insurance is the law of large numbers. The more people are insured, the higher the certainty with which an insurance company can forecast the probability of certain outcomes. It must be able to accurately forecast these outcomes to ensure it has enough funding to pay out claims. The persons in charge of this process are called actuaries.

For life insurance, actuaries estimate the life expectancy of an insured based on risk factors like age and family health history, among others. For auto insurance, they estimate an insured driver's likelihood of being involved in accidents or having their car stolen based on driving history, age, location, etc. And for home insurance, they look into the likelihood of property damage or natural disasters based on the home's age, condition and location. The actuary will also try to predict how much money the insurance company will likely have to pay out on covered claims.

Based on these and several other risk factors, actuaries then determine the premiums the insured will pay in exchange for coverage. Ultimately, it's underwriters who have the final word on premiums. Underwriters determine whether the applicant is insurable and, if so, the premium amount they will pay for the level of coverage they purchase.

Main components of an insurance policy

All types of insurance policies are structured differently, and there are even variations among the same categories of products. Nevertheless, there here are a few core concepts universal to most types of insurance:

  • Premium: The amount of money you pay for coverage. Depending on the policy, premiums may be paid monthly, weekly, quarterly, annually or as a lump sum. As a rule, the higher your likelihood of a claim, the higher your premiums. In the case of life insurance for example, a younger and healthier applicant may be offered lower premiums than an older applicant with pre-existing conditions.
  • Deductible: The amount of money the insured must pay before coverage kicks in. As stated in the previous section, deductible amounts have an impact on premiums.The higher the deductible, the lower the premium and vice-versa. However, not every policy will include a deductible.
  • Policy limits: Policy limits are the maximum a policy will pay out for a covered event. One common example of policy limits is in the case of dental coverage, a lifetime limit on orthodontic benefits.

Always read your policy thoroughly to understand the scope of coverage and policy exclusions. Ask your insurance agent plenty of questions if there's something you don't understand, and don't be afraid to ask more than once.

Types of insurance

If there is a possibility of financial loss, there is likely a policy that can cover it. With that in mind, here are some of the many types of insurance available:

Car insurance

Car insurance is meant to offset the financial impact of unforeseen events related to your automobile.

Auto insurance provides coverage for:

  • Theft, collision or liability. The policy will specify how much the insurer will pay and under which circumstances.
  • Damage to other cars as well as any injury to other persons involved.

Unlike other types of insurance, car insurance is legally required to own and operate a vehicle in most U.S. states — except for New Hampshire. In Virginia, driving without insurance could result in a fee.

Dental insurance

Health insurance doesn’t always include coverage for dental treatment. In such cases, dental insurance can provide much-needed financial relief by paying for (or reimbursing) some or all of the cost of treatment.

Dental insurance usually covers three levels of care:

  • Preventative and diagnostic care, such as x-rays and cleanings.
  • Basic restorative care, which includes fillings and root canals.
  • Major restorative care, which covers dentures, bridges and crowns.

Homeowners insurance

While not required by law, if you're financing your home, mortgage lenders will require you to maintain homeowners insurance for the duration of the loan.

Homeowners insurance typically covers:

  • Damage to your home caused by covered perils such as fire, wind, theft and falling objects, among others.
  • Personal liability, which pays the medical bills and lost wages of guests that become injured or suffer an accident on your property. It can also cover your legal fees in the event of a property damage or bodily injury lawsuit.

Life insurance

Most insurance policies are designed to repair or replace something. In the case of life insurance, the purpose of the policy is to replace the insured's lost income upon their death by paying out a tax-free death benefit to the policy's beneficiaries.

There are two main types of life insurance: term life and permanent life (including whole life insurance). The main difference between the two is how long the coverage lasts. While term life insurance only provides coverage for 10-30 years, permanent life insurance policies are meant to last a lifetime. Regardless of the type of life insurance, the younger and healthier you are when you purchase coverage, the lower your premiums will be.

Depending on the insurance company, you may be able to augment or modify coverage through policy riders. Some of the more common riders include:

  • Spouse coverage, which pays out if the spouse of the primary insured dies
  • Child coverage, which pays out if the specified child or children of the primary insured die
  • Accelerated death benefit, which allows the primary insured to access a portion of the death benefit if terminally ill

Long-term care insurance

When you're older and can no longer perform certain activities on your own, a long term care policy could help cover the costs associated with long term care. In order to trigger LTC benefits, the insured has to be unable to perform at least two out of six activities of daily living: personal hygiene, dressing, using the bathroom, ambulation/transferring, continence and eating.

There are a couple of different types of long-term care coverage:

  • A traditional long-term care insurance policy can reimburse you for some of the costs of the care you receive at home, at a nursing home or in a residential care facility.
  • Hybrid long-term care policies typically combine two types of coverage: a life insurance policy or qualifying annuity and a long-term care rider. These plans will pay out a guaranteed death benefit to your beneficiaries if you don't use the long-term care benefits. Because of these features, hybrid policies can be much more expensive than stand-alone long-term care insurance.
  • You may add riders to your long-term care policy that increase or modify coverage, such as one that adds inflation protection to prevent your benefit from losing value as the cost of living increases.

Motorcycle insurance

You may be inclined to think about motorcycle insurance as car insurance for your bike and, for the most part, you’d be right. One interesting difference between the two is the requirement to wear a helmet. Helmet requirements vary by state, and the insurance company may deny your claim based on whether or not you were wearing the right type of helmet.

Besides liability, other motorcycle coverage options include:

  • Collision coverage, which pays to repair or replace your bike if you're in an accident with another vehicle.
  • Comprehensive coverage, which covers your vehicle against damages caused by theft, vandalism or fire.
  • Most insurers also offer coverage for custom parts and accessories.

Pet insurance

This coverage helps to mitigate the financial impact of veterinary care. As a rule, the younger and healthier your pets are when you purchase the policy, the lower your premiums will be. Nevertheless, premiums will increase as your pet ages.

Most pet insurance policies work on a reimbursement basis, which means you will need to cover vet bills upfront costs and the plan will reimburse you once you submit a claim. And since most plans cover 70% to 90% of eligible costs, you'll still have to pay 10% to 30% of the bills (your copayment).

Pet insurance can be broken down into three types:

  • Accident-only policies, which are more affordable and cover only mishaps and unforeseen issues such as poisonings, broken bones, etc.
  • Accident and illness policies, which cover both accidents and illnesses like cancer and hip dysplasia (as long as your pet didn't present symptoms before coverage began).
  • Wellness policies, which tend to be the most expensive and cover only preventive and routine care such as vaccines and dental cleanings.

Renters insurance

Though renters insurance may sound like homeowners insurance for renters, it is worth noting that this type of policy doesn’t cover the property itself.

  • This type of insurance is designed to protect a renter’s personal belongings against theft, fire, certain natural disasters, and other perils.
  • It also includes liability protection and covers additional living expenses when the renter is unable to live in the dwelling due to a covered incident.

RV insurance

A lot of the same information about car insurance applies to RV insurance. However, since RVs may be used occasionally or as primary residences, there are several other coverage options for those who live in their RVs full time.

Common RV insurance options include:

  • Comprehensive coverage, which pays for damages caused by theft, vandalism, natural disasters, fire or other non-collision accidents.
  • Property damage or liability coverage, which pays for damages that you cause to another person’s property or vehicle.
  • Campsite/vacation liability coverage, which helps pay legal costs if you’re found at fault for the injuries suffered by a non-family member while at your campsite or in your RV.

Travel insurance

Travel insurance is meant to stave off the effects of last-minute travel plan changes and cancellations.

  • From canceled flights to baggage delay and accidents abroad, travel insurance covers a wide variety of scenarios.
  • Several companies offer optional riders (add-ons) that allow you to customize coverage to your needs. Common riders include cancel for any reason (CFAR) coverage, adventure sports coverage, pre-existing medical condition coverage, rental car insurance, and many more.

Which insurance is right for you?

You might have a need for every type of insurance listed here or none of them; only you can decide which option is right for you. Keep in mind that, regardless of whether or not you want insurance, certain types of coverage are either required by law (such as auto insurance) or by a third party (such as homeowners insurance).

A more pragmatic approach to determining your insurance needs is to take stock of your finances and decide whether you could financially recover from a loss without a policy. Those without enough savings to cover a major emergency may find insurance to be a relatively affordable hedge against risks.