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All About Insurance | The Purpose and Function of Insurance

 The Purpose and Function of Insurance

Insurance is not meant as an ATM or piggy bank to store wealth until it is needed. Most people would hope to never need to claim insurance benefits because the most common precipitator of benefits claims is some sort of disaster, whether personal or more far-reaching. There are many purposes of insurance, but the predominant one is to avoid catastrophic financial liability in the future – and thereby ensuring peace of mind.

First off, what is insurance?

Insurance is a tool to reduce financial loss or hardship.

It is a contract between the insured and an insurance provider under which the insured can be paid for certain losses. The insurance provider pools clients' risks to make payments affordable for the insured 

It is protection that can help cover the cost of unexpected events such as theft, illness, property damage, or death.

The protection or coverage you receive can be for a limited 

period or throughout your lifetime.

In return for the protection, you pay a premium. Premiums are the amount you pay periodically, depending on the type of insurance and what is stated in your policy. The amount of premiums you pay are based on the probability that you will suffer a claimable loss. Other factors that are considered in computing premiums can be the insured's age, health, lifestyle or family history.

For health, dental, home, and auto insurance policies, the amount of premiums also depends on the deductible. This is the amount of your claim you agree to pay before the insurer pays the rest. Of course, choosing a higher deductible will lessen your premiums because you are agreeing to pay for a larger part of your loss.

Insurers put premiums to pay claims costs, investments, and operational expenses. They practice diligent financial management so that claims can be paid. For instance, they invest in low-risk investments that can be easily liquidated in case they need to pay out claims. They also set money aside as a legal reserve. They are required by law to maintain this amount. The legal reserve guarantees that an insurer can pay a large number of claims within a short period (such as in cases of disaster, for example).


Legal Requirements and Protection Against Financial Liability

Some types of insurance, such as auto and workman's compensation (for businesses), are required by the law. This regulation ensures anyone harmed by another's actions does not further suffer from the liable party's lack of assets. If someone maims you in a car accident because they were negligent, the legal requirement of auto insurance guarantees you do not suffer secondary or tertiary consequences from lack of assets on the liable party's side. Your medical costs will be covered, regardless of you or the liable party's financial assets. A similar idea mandates workman's compensation and other insurances.

Financial liability minimization is a prime motivator. Malpractice, auto, and professional insurances are designed to protect individuals or businesses whose actions may cause harm to someone else. Since harm can lead to judgments exceeding an individual or business's assets, insurance sets an upper limit on losses in the case of a judgment against the insurance holder.

Protection Against Financial Ruin

Even if you are not liable for any wrongdoing, you may fall victim to circumstances and require protection. Another very common purpose of insurance is to negate the possibility of financial ruin. Auto insurance fits this category for the party at-fault. Disaster, health, and business insurances also fall under this purpose. Meeting litigation judgments or re-establishing yourself after a disaster are two important reasons to carry insurance.

Insurance intended for personal possessions, such as fire and renter's insurance, gives peace of mind to the beneficiaries because they know there is not certain bankruptcy in the future if the unlikely scenario of a disaster plays out. Not carrying insurance, especially for critical aspects like health and most people's largest asset (their home and vehicle) , can lead to an insurmountable financial problem from a single moment of destruction.


Policy Basics: Common Terminology and Mechanisms

As stated above, the main reason to carry insurance is to mitigate financial liability. This is done by spreading the risk among several participants in similar-risk pools, which then may or may not trigger payouts. Insurance is not meant to provide steady wealth, and indeed the amount paid into an insurance plan will likely be more than the payout.


Risk-Spreading Mechanism

As an example, consider a pool of homeowner insurance participants. Every month, the insured pay a premium into a pool, which is the source of the benefit money. If one participant's house burns down, the insurance company allocates some of the assets in the pool to that participant. Most participants never receive any money, because they have no legitimate claim (i.e., their house is never destroyed). Hence all participants paid indirectly for one participant's house, but they all enjoyed the benefit of coverage in the case that a disaster befell them. Hence risk is spread among all. 

This mechanism can and does break down. During disasters when many claims are made, an insurance company's assets could conceivably fall short of the legitimate benefits expectations. A famous example is AIG during the credit crisis in 2008 – claims against policies held by the company overwhelmed the company and it collapsed. To avoid this kind of failure, insurance companies are required to have minimum statutory reserves.


When people buy insurance, they put their money into a pool with many others. Some of that pool of money helps the policyholders who suffer a hardship in that period. The hardship can be home, auto or business losses. You are covered only for losses written in your contract, not for predictable events.

When a hardship or loss occurs, a claim is made. This is an official request for the insurer to pay for a covered loss. The insured's agent or broker can assist in claiming benefits. Supporting documents will be required, depending on the type of loss (for example, photographs of an injury or property damage for an accident or property insurance claim, or a death certificate for a life insurance claim) during claims processing or claims investigation. 

Calculation

Premium and limits calculations are made by the underwriter, who accepts financial liability on your behalf. The underwriter considers many factors relevant to the type of insurance. Actuaries use statistics and mathematical models to determine your rates and settlement.

Statistics and probability are a major part of the calculation. If you feel you are overpaying, remember that insurance policies are usually based on pools and assumptions. Other companies may treat your situation as less risky and hence offer you a lower premium or better terms (limits, deductibles, coverage periods). Make sure to shop around if you think you can get a lower rate.

Common Terms

Like all industries, there is a set of important terms used to describe complex subjects. Here are a few terms you should be familiar with:

Premium – periodic payment by insured to insurer to cover future claims

Deductible – amount the insured must pay before the insurer pays out

Lifetime Limit – upper limit the insurer is required to pay over the policy lifetime

Annual Limit – similar to lifetime, except per year

Liability Limit – upper limit per claim

Annuity – yearly payment (usually a settlement) which spreads a full benefit out over time

Underwriter – company or person (the insurer) who accepts liability for a risk, thereby transferring risk from the insured to the insurer 

Collateral – an asset that is considered at-risk if someone fails to meet financial obligations (defaulting on a mortgage puts the house (the collateral) at risk of being repossessed)

Structured Settlement – often an annuity, but not always; this is a benefits payment scheme over time

Rider/Endorsement – a specific change to a basic policy, intended for somewhat common deviations or to customize a policy to a particular insured

Surcharge – extra cost added to basic premium, usually due to at-fault claims or legal action (a traffic violation often results in a surcharge, which can be added in the middle of a policy period)

Actuary – person who determines rates and settlements for an insurance company based on statistics and mathematical models

Adjustor – person who assesses the extent of damage in an incident, which is used as the basis for the settlement offer

Different branches of insurance also have different terms depending on the branch. "Liability only" and "bodily injury" make sense for auto insurance, but it doesn't make as much sense for deposit insurance.


Policy – a legal contract between you and the insurer. It details what risks are covered, under what circumstances the insurer will make a payment to you, how much money and what type of benefit you will receive if you make a claim.

Policyholder – the insured or the person covered under the policy.

Coverage – the amount of protection you have bought. It is also the maximum amount the insurance company will pay you if you claim loss or event covered by your policy.

Benefit – the amount the insurer will pay you if the insurer accepts your claim.

Premium – the amount you pay for the insurance.

Cash value – this is the amount the insurer pays to the policyholder when a life insurance policy is cancelled. It can also be an amount added to the death benefit and can be paid upon the insured's death. This term is used with permanent life insurance policies.

Death benefit – the amount the insurer will pay the beneficiary or beneficiaries upon the insured's death

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