What Is Insurance?

Insurance Explained in 5 Minutes

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Insurance is a written contract between an insurance company (insurer) and an individual or entity for which the insurer provides protection against financial losses. The insurance company is able to provide this protection by pooling risk from a large group of individuals and entities with similar needs. 

Insurance is generally designed to protect you in the event of a loss you can’t otherwise pay for, such as if you total your car or require expensive surgery. If you don’t carry insurance, you may be 100% responsible for all related costs and expenses when an accident happens. Learn more about insurance, how it works, and the types of insurance available. 

Definition and Example of Insurance

An insurance policy is a legal contract through which an individual or entity receives protection against unexpected financial losses from an insurance company. In exchange for a premium, the insurance company will reimburse you for losses should a covered contingency arise.

Let’s say you just bought a car and want to buy insurance, as your state requires. You and the insurance company would enter into a contractual agreement in which the insurance company agrees to protect your car against certain types of damage. Six months later, you’re involved in an accident that ruins your front fender. If your car insurance policy is in force and the damage to your fender is covered, your insurer will pay to repair the damage to any extent or limits specified in the policy. 

An insurance company will only reimburse for losses described in the policy. Read the policy carefully before buying it to ensure you understand your insurer’s responsibilities and your own in the event of a loss.

How Insurance Works

Insurance is a way to manage unforeseen risks.  The instrument by which it does this is a written contract between an insurer (the insurance company) and a policyholder (the individual or entity that gets the policy)—these documents are the insurance policy. 

The policyholder isn’t always the insured. For instance, a company may buy an insurance policy (making it the policyholder) that protects its employees (who are the insured).

An insurance policy remains in force for a specific period, known as the policy term. When the term ends, you usually have the option to renew the policy, terminate it, or buy a new one. When you buy an insurance policy, you should understand what it covers if there are any exclusions that limit coverage, and the responsibilities you must fulfill for the insurance company to reimburse losses. 

One of your responsibilities is understanding the basics of your insurance contract and to read the policy fine print. An insurance contract typically will have these basic parts:

  • Declaration Page: The insurance declaration page is the first page of your policy and it identifies policy basics, including the insured, what risks are covered, the policy limits, and the term of the policy. 
  • Insuring Agreement: The insuring agreement summarizes what the insurer promises to do in exchange for your premium. 
  • Exclusions: The exclusions section comes after the Insuring Agreement and highlights what your policy doesn’t cover. 
  • Conditions: The conditions section has provisions that qualify or limit your insurer’s promise to reimburse or perform. The insurer can deny a claim if you fail to meet these conditions.

Reading and understanding your policy fine print may help you avoid disagreements and problems with your insurer in the event of a loss.

Another part of your responsibility is paying the insurance premium, usually monthly, semiannually, or annually. The amount of premium you will pay depends on the amount of risk you present to your insurer and the amount of coverage you have. Besides the premium, you may also be responsible for: 

  • A deductible: You must pay this amount first before your insurer pays your claim. 
  • Coinsurance: Depending on the type of insurance, you may be responsible for a percentage of covered expenses once the deductible is met. For example, you might be responsible for 20% of covered costs, while the insurer is responsible for the remaining 80%. 

Some insurance policies let you choose your deductible. Typically, a lower deductible translates to a higher insurance premium. 

Types of Insurance

There are many different types of insurance available, but the most common types are described below. 

  • Health insurance: Health insurance helps cover the cost of your medical bills, doctor costs, and prescription drugs when you seek medical care. Once you obtain coverage, your insurer agrees to cover part of your medical costs, usually after your deductible is met, then as a percentage or a specific dollar amount up until an out-of-pocket maximum. After you’ve paid this amount, the insurer pays the remainder of your covered costs for the rest of the year.
  • Life insurance: Life insurance promises to pay your survivors—the designated beneficiaries on your life insurance policy—a sum of money when you pass away. Life insurance policies do not have deductibles or coinsurance.
  • Homeowners insurance: Homeowners insurance protects your physical dwelling, personal property, and other structures against loss or damage caused by different perils. You’re also protected if someone is injured while on your property. Unlike health insurance, you pay the deductible each time you file a claim.
  • Auto insurance: Auto insurance is a way to protect yourself and your car, should an accident occur. It provides coverage for liability (both bodily injury and property damage liability), medical payments, and collisions. In most states, it is illegal to drive without auto insurance. Like homeowners insurance, you’re responsible for paying the deductible each time you file a claim.
  • Business insurance: Business insurance is the umbrella term for a collection of policies that protect your business from financial losses that result from property damage, accidents, and professional errors, among other situations. 

Key Takeaways

  • Insurance is an agreement through which an insurer promises to pay benefits or reimburse losses in exchange for premium payments by the policyholder. 
  • An insurance company will only compensate a claim for losses covered in the insurance policy. 
  • There are different types of insurance. Health, auto, homeowners, and life are the most common insurance policies.