*Content includes branded mentions of our sponsor Lemonade.
Insurance is an agreement between an individual policy (or a business) and an insurance company. Under this agreement, the policyholder pays premiums to the insurer in exchange for financial compensation in the event of a covered incident. For example, auto insurance will reimburse an insured driver for the cost of auto repairs (up to a limit) after an accident.
Also known as: indemnity, assurance, coverage
To explain what insurance is in simple terms: it's a way to protect your loved ones, property, business and lifestyle from financial losses and unexpected costs. By paying an insurance provider, you receive coverage that will preserve your way of life in case of unfortunate events. Some insurers, such as Lemonade, offer several different types of insurance policies, while other focus on a specific area. Read on to learn about insurance, how it works and the types of coverage available.
Table of Content
- How does insurance work?
- Main components of an insurance policy
- Types of insurance
- Coinsurance vs. copay
- Deductible vs. out-of-pocket expenses
- Which insurance is right for you?
- What is insurance FAQ
How does insurance work?
A core concept of how insurance works is the law of large numbers. The more people are insured, the better an insurance company can forecast the probability of certain events, such as car accidents, that would require the company to pay out claims. The company must be able to accurately forecast these events to ensure it has enough funding to pay out these claims. The people in charge of this forecasting process are called actuaries.
For life insurance, for example, actuaries estimate the life expectancy of an insured individual based on risk factors like their age and family health history. For auto insurance, actuaries estimate an insured driver's likelihood of being involved in an accident or having their car stolen based on their driving history, age, location, etc. And for home insurance, actuaries analyze the likelihood of property damage or natural disasters based on the home's age, condition and location. The actuary will then predict how much money the insurance company will have to pay out on covered claims.
Based on these and other risk factors, the actuary determines what premiums the insured will pay in exchange for coverage. Ultimately, it's underwriters who have the final word on premiums. Insurance underwriters determine whether an applicant is insurable and, if so, what premium amount they will pay for the level of coverage they purchase.
Insurance is also a way of managing risk. Understanding basic risk management methods is a great way to decide what insurance is right for you. Risk management methods include the following.
Not participating in an activity where damages may happen. For example, one way to prevent being in a car crash is to never get in a car.
When you decide to reduce risk, you understand that an unfortunate event may happen but take steps to minimize it happening. Instead of never getting in a car, for example, you commit to following the rules of the road and not breaking any traffic laws. A car accident may still happen, but you have taken measures to minimize the possibility of causing one.
When you retain risk, you may or may not take measures to reduce it, but you understand that the event may happen regardless of how you prepare and decide to deal with it if or when it happens. If you've decided to retain, or accept, that one risk of driving a car is causing an accident, you may opt to simply pay for any repairs out of pocket.
When you understand that a given event may happen, but you don’t want to retain it and you decide reducing it is insufficient, you may decide to transfer the risk to a willing third party. Insurance is an example of risk transfer. For example, you pay a premium to an insurance company, transferring your risk of a car accident to the company. The company will pay up to a certain amount to repair your car in the event of an accident.
Main components of an insurance policy
All types of insurance policies are structured differently, and there are even variations within the same types. Nevertheless, there are a few core concepts shared by most types of insurance:
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.
Some insurance companies, such as Lemonade, also give back to the community. When you sign up for one of their homeowner’s policies, you pay a flat fee — and a large part of the money collected that hasn’t been dispersed through claims then goes into its Giveback program.. Up to 40% of unused claim money is sent to organizations chosen by Lemonade customers.
The amount of money you must pay before coverage kicks in. Your deductible amounts will impact your premiums. The higher the deductible, the lower the premium, and vice-versa. However, not every policy will include a deductible.
The maximum amount 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 insurance policy thoroughly to understand the scope of coverage and policy exclusions. Don't be afraid to ask your insurance agent if there's something you don't understand.
Types of insurance
If there's a possibility of financial loss, there is probably an insurance policy that can cover it. With that in mind, here are some of the many types of insurance available:
Car insurance offsets the financial impact of unforeseen events related to your car.
Auto insurance provides coverage for:
- Theft of your car
- Damage to your car
- Your liability, if the damage is your fault
- Damage to other cars as well as injury to others 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.
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.
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
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
Though renters insurance may sound just like homeowners insurance, but for renters, it’s worth noting that this type of policy doesn’t cover the property itself.
- Renters 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.
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 to 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
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
Travel insurance is meant to stave off the effects of last-minute travel plan changes and cancellations.
- From canceled flights to baggage delays 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.
Long-term care insurance
When you're older and can no longer perform certain activities on your own, a long-term care (LTC) 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.
You might 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
If you have a boat or other aquatic vehicle, boat insurance is highly recommended, though only Utah and Arkansas require it. Boat insurance premium payments depend on many factors, including the type of your watercraft, where you will use it and which months of the year you will use it.
Boat insurance policies typically provide:
- Personal property coverage, which protects against property damage resulting from an accident, theft or vandalism
- Liability coverage, which protects you if your watercraft damages someone else’s property
- Underinsured/uninsured boater coverage, which protects you if an underinsured or uninsured boat causes damage to your boat
- Medical payments coverage, which reimburses medical bills when you or one of your passengers get injured
- Emergency towing and assistance coverage, which reimburses the cost of emergency assistance for your watercraft
Coinsurance vs. copay
Coinsurance and copay, short for copayments, are usually related to health insurance policies. Coinsurance splits medical expenses between you and an insurance provider after you have maxed out your deductible. For example, in the case of a 70/30 coinsurance split, the insurance provider will cover 70% of your eligible costs after you pay your total deductible amount.
A copay is similar to coinsurance, but it is a set dollar amount instead of a percentage. Unlike coinsurance, copays can take effect before you pay your yearly deductible. Copays don’t count toward your deductible but do count toward your out-of-pocket maximum. Copay amounts vary depending on the type of service, such as purchasing a prescription or visiting the emergency room.
Here are some of the differences between coinsurance and copay:
|How it’s calculated
|When it applies
|Deductible must be paid in full
|Deductible does not need to be paid in full
|Relationship with deductible and out-of-pocket maximum
|Not counted toward your deductible or your out-of-pocket maximum
|Not counted toward your deductible but counts toward your out-of-pocket maximum
|Percentage applied equally to all eligible costs
|Costs vary depending on service
Deductible vs. out-of-pocket costs
A deductible is an amount you pay throughout the year before your health insurance provider will contribute to your costs. Once you pay your deductible, you’ll split the costs of services with your insurer until you reach your out-of-pocket maximum. Higher deductibles usually mean lower monthly premiums.
An out-of-pocket maximum is the annual amount you must pay by yourself before your health insurance provider starts to cover 100% of your qualifying expenses. Your out-of-pocket maximum will always be greater than or equal to your deductible.
Here are some of the differences between deductible and out-of-pocket payments:
|Set amount agreed to in your policy
|Set amount agreed to in your policy that includes your deductible
|Result once reached
|Insurance provider pays a percentage of coinsurance costs
|Insurance provider pays 100% of eligible costs
Which insurance is right for you?
You might need every type of insurance listed here or none of them. Only you can decide what is right for you. Keep in mind that, regardless of whether or not you want insurance, certain types of coverage are required either 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.
What is insurance FAQ
What is an insurance premium?
An insurance premium is an agreed-on amount that you pay on a regular basis for insurance. Insurance premiums are usually paid monthly but may be paid semi-annually, annually or as a lump sum.If you stop paying your premiums, you'll lose your insurance coverage. Premium costs vary depending on factors such as the type of insurance policy, coverage amount, your age, health, gender, occupation and more.
What is coinsurance?
What is a deductible?
A deductible is an annual amount you need to spend on services before your insurance plan begins to cover your expenses. Once you pay your yearly deductible in full, you will split your healthcare costs with your insurance provider, depending on the terms of your policy.Unlike an insurance premium, you only need to pay toward your deductible if you accrue expenses. If you pay a high monthly premium for health insurance, your deductible will likely be low, and your policy will cover you after paying minimal out-of-pocket costs. If you are generally healthy and a medical emergency is unlikely to happen, you may opt to pay a lower premium each month but agree to a higher deductible.
What does "bonded and insured" mean?
What does self-insured mean?
"Self-insured" means an individual or a business foregoes using a third-party provider for financial protection. Instead, a self-insured person or company takes on liability risk themselves, paying for property damage, healthcare expenses or other unexpected events out of their own pocket.Self-insured parties set aside large amounts of money to cover unexpected costs instead of paying premiums that would allow them to get reimbursed by insurance companies.
Summary of What Is Insurance?
Insurance is an agreement between an individual or business and a third-party provider that protects against costs due to unforeseen circumstances. By buying into insurance plans such as life, homeowners, travel and health insurance, you can relax knowing your money and property will be covered in the event of an emergency.