Insurance
In insurance, the insured makes payments called "premiums" to an insurer, and in return is able to claim a payment from the insurer if the insured suffers a defined type of loss. This relationship is usually drawn up in a formal legal contract, also known as a policy. The contract will set out in detail the exact circumstances under which a benefit payment will be made and the amount of the premiums.
In one classic example of insurance, a ship-owner insures a ship and receives payment if the ship is damaged or destroyed. This example is one of the earliest uses and developments of concepts like insurance. Interestingly, ships are now more often insured through risk pooling and spreading organizations such as Lloyd's of London because the loss of a large ship going down is too great for one insurer to accept.
In the case of annuities, such as a pension, similar concepts apply, but in some sense in the reverse. When applied to annuities, the terms risk and loss are somewhat different from traditional insurance as they concern the chances of living beyond life expectancy and the need for income during the period between annihilation and death.
Insurance attempts to quantify risk by pooling together a large number of risks. This makes use of the law of large numbers. As applied to insurance, this means that the greater the number of similar risks, the greater accuracy with which insurers can estimate the overall risk.
For example, many individual people purchase health insurance policies and they each pay a small monthly or yearly premium to an insurance company. When a policyholder gets ill, the insurance company provides money to cover medical treatment. For some individuals the insurance benefits may total far more money than they have ever paid into the insurance policy. Others may never make a claim. When averaged out over all of the people buying policies, value of the claims even out. Insurance companies set their premiums based on their calculated payouts. They plan to take in more money (in premiums and in profit from the float, see below) than they pay out in the end to cover expenses. For-profit insurance companies set their rates to make a profit rather than to break even.
Insurance companies also earn investment profits, because they have the use of the premium money from the time they receive it until the time they need it to pay claims. This money is called the float. When the investments of float are successful, they may earn large profits, even if the insurance company pays out in claims every penny received as premiums. In fact, most insurance companies pay out more money than they receive in premiums. The excess amount that they pay to policyholders is the cost of float. An insurance company will profit if they invest the money at a greater return than their cost of float.
Insurance can also be thought of as a wager or bet that executes over the policy period. The insurance company bets that you or your property will not suffer a loss while you put money on the opposite outcome. The difference in the fees paid to the insurance company vs the amount they can be held liable for if an accident happens is roughly analagous to the odds one might expect when betting on a racehorse.
Some Tips for First Time Insurance Buyers
When you buy insurance, you're really buying something that you hope you'll never have to use. But if you ever do need to file an insurance claim, you'll understand why having the right amount and right types of coverage are important.
Decide how much insurance you need
You can't stop bad things from happening. But you can protect yourself financially by purchasing insurance. How much insurance you need depends on a lot of factors including how much you owe and own, how much your assets are worth, whether you have dependents, and how much out-of-pocket cost you could afford to bear. You can estimate your coverage needs using calculators or worksheets available on-line, but it's a good idea to sit down with an insurance agent or broker who can thoroughly evaluate your needs.
Comparison shop
No matter what type of insurance you're buying, the process is essentially the same. Once you've decided what type of insurance and how much coverage you need, you can begin contacting insurance companies online, directly by phone, or through an insurance agent or broker to obtain quotes. Get quotes from several different insurers because premium cost can vary widely.
But compare the coverage offered, too. A policy might cost less because it offers fewer, or different, features and benefits. And make sure the company you've settled on is reputable, with good customer service and claims-paying ability. All insurance companies are rated by major rating agencies on their ability to pay claims. You can access these ratings online, through public libraries, or through insurance company literature.
Understand what you're buying
An insurance policy is a legal contract that may be loaded with technical terms that are hard to understand. But read it anyway before you sign on the dotted line to find out about the coverage you're buying. For instance, the policy will tell you:
Who or what is covered
What coverage exclusions and limitations apply
When coverage begins and ends
How much coverage is provided
How much you'll pay for coverage (the premium)
How you report a loss or file a claim
It's always a good idea to ask an insurance professional to explain any terms, conditions, or benefits that you don't understand.
Evaluate your insurance needs periodically
As your life changes, your insurance needs change, too. So every once in a while (annually, some experts suggest), review your insurance to see if you need more (or less) coverage or an additional type of coverage. Here are some times in your life when you'll definitely want to re-evaluate your insurance needs:
You're getting married or divorced
You're starting a family
You're renting an apartment
You're buying a house or a car, or making a major purchase
Your child is going off to college
You're starting a new job or becoming self-employed
You're buying or selling a business
Your income increases or decreases substantially
You're taking care of an aging parent
You're retiring
Make your life insurance policies work for you by taking the time to periodically review your needs and coverage’s.
