- Insurance can minimize your financial liability in the case of a catastrophe and give you peace of mind.
- When shopping for insurance, it is important to assess your individual needs to determine what insurance(s) you will actually require.
The world is a dangerous and risky place. Various disaster can befall any individual, and we as a species survived thanks to combined resources and knowledge – after all, the explosion of technology in the past century finds its foundations in previous work. A magnificent concept would be a mechanism to mitigate risk in some kind of pool, spreading the risk among participants, so no single party is left to carry a burden single-handedly. That mechanism is insurance.
The Purpose and Function of Insurance
Insurance is not meant as a piggy bank to store wealth until it is needed. In fact, most people would hope never to 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.
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 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.
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.
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.
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 the insurer to cover future claims
- Deductible – the 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 – the person who determines rates and settlements for an insurance company based on statistics and mathematical models
- Adjustor – the 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.
Types of Insurance
There are plenty of types of insurance. I have outlined the most common, some less well-known but still important, and some of the stranger insurance policies available. Remember insurance is meant to mitigate risk by pooling assets for several participants.
- Health – there are myriad health insurances
- Life – paid out to survivors of the insured
- Long-Term Care – for long-term medical care needs
- Auto– all sorts of vehicles, and it is usually mandated by law
- Homeowners – often do not cover “acts of God” / disasters
- Disaster – tornado, flood, earthquake, etc.
- Kidnap and Ransom – used by the wealthy but also travelers and workers in dangerous areas of the world
- Renter – for personal belongings, not the building
- Deposit – such as the FDIC, which automatically protects most depositors at banks
- Travel – usually covers medical and other expenses while abroad and the insured’s home country policies do not apply
- Pet – for your loveable furry family members
- Income and Payments – guarantees payment of common individual liabilities (bills, mortgage) or a portion of income (useful if savings would be inadequate upon disability or job loss)
Business and Professional
- Malpractice – doctors and other professionals whose expertise is their job
- Errors and Omissions – for advice and service providing professionals (accountants, lawyers, etc.) to limit negligence claims liabilities; also known as Professional Liability Insurance
- Workers Compensation – to protect businesses when they must pay injured employees
- Landlord – to cover problems with a rented building
- Casualty – for employee deaths or deaths caused by business operations
- Ransom and Kidnap – for employees
- Data Loss – more and more relevant insurance meant to protect companies from financial losses due to loss of data, either malicious or accidental
- Auto – for fleets
- Multiple Peril – bundles several common insurances together to ease the payment process (ex., employee health, casualty, and ransom insurance plus auto and building)
- Crop – used by farmers to protect against financial ruin if crops are destroyed
Some other types of “insurance” are not termed insurance but act like insurance. These are derivative-based financial agreements, such as Credit Default Swaps (CDSs), which played a major role in AIG’s downfall. They are still widely traded, and for insurance companies, there is an incentive to customize policies for large corporations. This is the securitization of risk.
Timing – When to Purchase and When to Reconsider
Insurance is intended to mitigate financial risks. However, insurance is not always necessary. There are insurance policies for so many possible problems and many of them simply are not relevant to all people or entities.
Some of the most important insurances regard life. Health and life insurance are practical and are much cheaper to purchase when the insured is far from needing them. Insurance is a business of probabilities, and a young, healthy, boring individual is much less likely to make a claim on health or life insurance in the near future. Conversely, a customer who is 95, smoked and drank all his/her life, and still enjoys skydiving once a week is much more likely to claim health or life insurance benefits. Timing is essential when purchasing insurance.
Other insurances, like auto, are only required when one owns or uses a car. If you plan to live in a major city with excellent public transit, your auto insurance is irrelevant (rentals usually have their own insurance attached). Purchase only what you expect to need, and there is little reason to purchase a plan that extends beyond that.
Entering into a policy early will affect lower premiums, but one must be careful not to discount the time value of money or possible life changes. Furthermore, applying earlier is better. Waiting can result in delays or denial, especially if a condition develops too much.
Remember, insurance is meant to mitigate future financial risks, and thereby it may ensure other important benefits, such as preventative medical care or income to purchase food after a major accident at work. Plenty of material is available online, and it may even prove overwhelming. Hopefully, we helped to simplify some things about insurance for you. If you are unsure about what insurance is right for you, there are professional insurance brokers who can offer some assistance in choosing the most appropriate plan for your needs.