How Does Insurance Work? Things You Should Know

how does insurance work

The term insurance is used to refer to a form of financial loss protection. It can be described as a risk management measure for uncertain losses, which helps an individual or assets to hedge against the dangers.

A body that offers insurance is known as an insurance carrier, insurer, underwriter or insurance company. On the other hand, an entity or individual purchasing insurance is referred to as a policyholder or an insured. The policyholder assumes a known or an insignificant guaranteed loss in terms of payment to the insurance company. To complete the insurance transaction, the company offers a promise to compensate the policyholder if the risk occurs. A loss must be flexible to be calculated financially regardless of whether it is financial or not. Besides, the damage should comprise something that the policyholder has an insurable interest in the form of possession, prior relationship, or indirect ownership.

How Insurance Works

The insurer gives the insured a contract known as the insurance policy, which describes the terms and circumstances necessary for compensation to take place. The fee an insurance company charges the insured before a risk as detailed in the insurance policy is known as a premium. In case of a loss to an insured, they (the policyholder) can report a claim to the insurer, if the cause of that loss is potentially outlined by the insurance company. The process of analyzing and compensating the insured is carried out by a claims adjuster.

Additionally, the insurance company may protect its own risk by taking an insurance policy with another insurer. This process is called reinsurance. The second company may, therefore, agree to carry some part of the risks. The sharing is common whenever the primary insurance company finds the risk too high to deal with.

Required By Law

The law requires everyone to have certain types of insurance when carrying out some activities such as motor insurance to drive. Also, a person’s mortgage requires buildings insurance, while life insurance is considered essential. Although individuals should avoid paying for unnecessary insurance, the idea of insurance is based on whether an individual can sustain any disaster that can strike them.

Some of the essential insurance policies cover various aspects of life, such as home, health, business, vehicle, and retirement.

How Insurance Is Obtained Or Given

customer gets an insurance

As mentioned earlier, premiums are paid regularly after the insured purchase an insurance policy. Also, any claim submitted to the insurer is subjected to terms of the policy. That is before a loss is compensated. Failure to make a claim means that no money will be received back. As a result, it is added to a collective pool together with other insured entities or persons covered by the same insurer. The policyholders’ premiums help to cover for the losses when one of them makes a claim.

Factors that determine the type of insurance

  • The reason one needs a cover
  • What an individual want to include in your cover
  • The amount of money one can afford to contribute
  • The duration that a person may need a cover
  • The individuals to cover (e.g. personal insurance, a loved one, or both)

How to Buy an Insurance Cover

  • Directly contact an insurance company. Most of them have online platforms with emails and phone numbers
  • Use the Independent Insurance Agents & Brokers of America (BIG i) to get an insurance broker for professional advice
  • Contact independent financial advisers. Visit to find professional financial advisers and specialist, or talk to the Association of Professional Financial Advisors
  • For the best deal of the specified type of policy, visit comparison websites

Calculation of the Premiums

To determine the cost of an individual’s premium, the insurers rely on risk data. They estimate and calculate the possibility of a happening that the policyholder is insuring against. The insurer must consider the degree of risk they are likely to experience. The more likely the happening is likely to take place, the higher the risk an insurance company might face; therefore, the premiums are set at a higher value.

premium calculation

The insurer considers two crucial aspects when determining the average amounts.

  • The likelihood in general terms the insured is going to make a claim
  • The difference between an average policyholder and the individual is another factor. The prospective policyholder might have a smaller or more significant risk to the company than a standard “insurance client”. For instance, a young driver with a supercar is more likely to encounter an accident than an older, experienced driver; thus, the former’s premiums may be higher

In one year, only a portion of all policyholders submit claims to the insurer.

Conditions of a Standard Policy

Different insurance policies have different terms and conditions, but three main principles exist across all forms of policies. They state that:

  • A cover can only involve the actual value of the item or property destroyed or lost (the cost of replacing it), but no mawkish value is added.
  • It can only be insured if there is an occurrence of many identical incidences insured against that can help the insurer to spread the likelihood of a claim among other policyholders. The insurance company must be able to calculate the possibility of a loss, which enables them to set the value of a premium in relation to the risk.
  • A loss should not result from a deliberate act

Impacts of Fraud on the Insured’s Insurance Payments

  • Research shows that insurance companies (especially those dealing with casualty and property) lose approximately $30 billion every year due to insurance frauds. Accounting for the other types of insurance brings the amount to about $80 billion. It is more likely to occur after major disasters and during a recession.
  • Organized fraud rings and individuals are responsible for fraud in various insurance transactions. The most common fraud schemes are a misrepresentation of facts during the application, inflating actual claims (known as “padding”), the charging of medical bills for a medical service not given, submission of claims for damages or injuries that never occurred.

The Regulation of Insurance Companies

Governments must overlook all legal businesses in a country. The state governments primarily regulate insurance companies. Insurance laws depend on the territory they are set and, hence, vary from country to country. The state legislature, for instance, may approve insurance laws, which are in turn administered by a chief insurance regulator in Columbia. Another example is Michigan: the Michigan Office of Financial and Insurance Regulation is the state agency that regulates insurance companies. The OFIR Commissioner is the chief insurance regulator in the country.

Various types of Insurance Companies

Different insurance companies cater to different customer bases and offer different products. The largest groups of insurance companies include property and casualty insurers; accident and health insurers; and financial guarantors.

office buildings in business district

Property and Casualty Insurers – These are companies that cover risks associated with accidents of non-physical damage — for example, car crash; harm or loss of personal assets; lawsuits; and others. The companies include Allstate, Nationwide, and State Farm.

Accident and health companies- They are the most common in the minds of people. They assist people who encounter physical harm. Some of the largest companies include Anthem, AFLAC, Aetna, and UnitedHealth.

Insurance Float

Insurance companies enjoy various advantages: they are allowed to invest using the pooled amount from their customers. This is common practice with banks, although the investment of insurance operators occurs on a larger scale. In some cases, this is called “the float”.

Float is as a result of an extension of money by a party to another without expectation of a refund unless an agreed event occurs. As a result, there is a positive cost of capital for insurance companies. This mechanism differentiates insurance operators from banks, equity funds, and mutual funds.

Events Following a Major Loss

The insurer controls the amount of contributions (premiums) to make sure there is enough money available whenever policyholders submit large claims.

Significant losses occur during natural catastrophes resulting in multiple claims. For example, Alberta experienced flooding in 2013 and assessments and compensations are ongoing. Also, there were about 700,000 claims in Quebec, New Brunswick, and Ontario after the 1998 ice storm which left damages of approximately $1.4 billion.

What an Insurance Policy Covers

The insurer compensates only the insured losses detailed in a policy. Therefore, one should thoroughly read the contract and consult the insurance company to know what is covered and what is not. An insurer cannot pay for all issues a policyholder experiences or cater to frequent home maintenance. The primary purpose of insurance is to target – and charge properly – any unknown event that may occur abruptly and are purely accidental. For instance, a person living in an area prone to flooding by a river and experiences floods during a known rainy season, this event is not accidental or sudden: it is inevitable and not insurable.

The Insurance Process

  • Depending on the amount of money that the insurance company deems necessary to pay for annual claims, the insurer calculates the premium to cover the business, home, car, or other resources.
  • The insured pays the premium on a monthly or annual basis. This is because the insurance company assumes the risk on the policyholder’s behalf.
  • The insurer keeps the premiums into a common pool. The large pool works for only a year at a time since the insurance policy is an annual contract.
  • Only a few people make claims every year. For that, the insurance company draws from the shared pool and pays for the losses.

Principles of Insurance

An insurance contract involving the company and an individual is governed by basic legal requirements and regulation. The most common principles legally quoted are listed below.

insurance concept
  1. Benefit insurance – The insurer has no right of recovery from the party that initiated the damage and should, therefore, pay for the losses irrespective of the fact that the policyholder has sued for damages by the negligent party. This law is stated in The Chartered Insurance Institute and includes personal accident insurance, among others.
  2. Indemnity – the insurance company covers the policyholder if an insured loss occurs, but only up to the latter’s interest.
  3. Uberima fides (Utmost good faith) – both the insurance company and the insured should practice good faith (fairness and honesty). Therefore, material facts should be unveiled during the time of the contract.
  4. Insurable interest – the policyholder must suffer a direct loss. When insurance on a person or property is involved, there must be an insurable interest. This means that the insured requires a “stake” in a property or a life in case of a loss. The type of insurance helps to describe the stake of a person in property ownership, the nature of the relationship between people, and more. This policy plays a significant role in differentiating gambling from insurance.
  5. Subrogation – the insurer has legal rights to chase recoveries on the policyholder’s behalf. For instance, the insurance company may sue the party responsible for the loss. Also, the firm may use special clauses to renounce its right of subrogation.
  6. Contribution – The insured is not supposed to have a financial gain exceeding the value of the damage. Thus, other insurers with a similar obligation to the policyholder contribute in accordance to some method.
  7. Proximate cause (CausaProxima) – The cause of a damage or loss is bound to the policy agreement without excluding the dominant cause.
  8. Mitigation – When an insured risk occurs, the owner of the asset must try to minimize the loss with an assumption that it was not insured.

Methods of Insurance

  1. Reinsurance – This occurs when an insurance company transfers a part of the risk to the reinsurer.
  2. Co-insurance – This occurs when two or more insurance companies share a similar risk
  3. Self-insurance – It is a case when a risk is not shifted to the insurer, but somewhat reserved by individuals or entities.
  4. Dual insurance – This is taking two or several policies with different insurers to cover the same risk. The companies contribute together instead of paying separate amounts to place the insured to the same financial position they were before the loss. However, contingency insurance may allow dual payment, for example, in life insurance.

Mark Jorel Snow

Mark Jorel Snow brings over 15 years of financial experience to help everyday people master their money. Mark is passionate about making complex financial topics simple. His down-to-earth explanations empower readers to take control of their finances with confidence. Mark specializes in creating tailored money strategies and providing unmatched personal support. When he's not coaching clients or penning his latest article, you can find Mark enjoying nature and time with family.

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