While the details of any insurance policy can be complex, it's relatively easy to explain the concept of insurance. The concept of insurance involves a transfer of risk from one party, such as an individual or company buying an insurance policy, to another, such as an insurance company. For example, if you purchase a homeowners insurance policy, you are transferring the risk that you will be faced with an expensive loss due to fire or another hazard to the insurance company.
Insurance Concepts and Coverage
With a typical insurance policy, the person or organization buying insurance, often referred to in legal terms as the insured, pays a regular fee called a premium to the insurer. If certain events happen as defined in the policy, the insurer is required to pay the insured to compensate for a loss.
For example, a health insurer is required to make payments if the insured party becomes ill or otherwise needs medical care, while property insurers are required to pay out after a fire, theft or other incident causing property loss or damage. More specialized insurance policies can also be written: For example, it's not uncommon for athletes, models or actors to ensure their bodies or even body parts, like their legs, against an injury or illness that could leave them unable to work.
Insurance contracts sometimes have a maximum amount that they will cover, so it's often important to find a policy that covers as much as your potential losses. Some insurance policies also have deductibles, which refers to an amount the insured party needs to pay before insurance will pay the rest. Health insurance typically has annual deductibles, and other types of insurance can have per-incident deductibles, where you as the insured must pay a portion of each claim before the insurer will cover the rest, similar to copayments on a health insurance policy.
The process of reporting an incident to an insurance company and getting paid for it is known as filing a claim. The employee of the insurer who investigates the claim to make sure that it's valid and determines what the insurer will pay out is typically known as a claims adjuster.
How Insurers Make Money
People buy insurance because they want to avoid a burdensome risk, like losing their assets in a fire, destroying their cars in a crash or going bankrupt from medical bills. Insurance companies effectively pool risk on behalf of their insured customers so that they can pay a manageable monthly premium rather than having to save potentially huge sums of money to budget for a potential, but unlikely, catastrophic loss. For-profit insurance companies also generally sell insurance with the expectation that they'll make money, which they can mostly do in one of two ways.
One is by charging premiums that, added up across all of the people the insurance company insures, are expected to come to more than the insurance company will pay out. Experts called actuaries help insurance companies calculate the risks of various events so that they can price premiums accordingly. The process of deciding how much an individual insured party should be charged and, potentially, if that party should be insured at all, is known as insurance underwriting.
Insurance companies can also invest premiums that they anticipate will pay out to insured customers in the future. This money is often referred to as float, and with shrewd investments, it can bring insurance companies a good rate of return. Regulators sometimes limit what insurance companies can invest in to make sure they don't take too many risks themselves with consumer funds.
When Insurers Buy Insurance
In some cases, insurance companies will themselves buy insurance, protecting against having to pay out a high amount of money in claims in a short period of time. This insurance is commonly called reinsurance.
While the idea of insurance companies buying insurance might seem strange, the concept is the same as when any other organization buys insurance. The companies are effectively pooling with other insurers, transferring the risk of a large payout to the reinsurance provider in exchange for a regular premium.
Reinsurers often find themselves paying out to insurance companies after widespread disasters, like hurricanes, wildfires or terrorist attacks.
Different Types of Insurance
There are numerous different types of insurance available today, in addition to one-off policies such as for celebrities insuring their legs.
Some of the most common include property insurance, which covers homeowners, businesses or renters against damage to their property and, often, liability for incidents that take place on their property. Life insurance is also quite common, providing a payout to the insured person's survivors when he or she dies. Auto insurance, which covers both liability from collisions and, in some cases, damage to the insured party's own car, is also required in many places.
Health insurance is also a major sector of the insurance market, covering medical bills when someone needs medical care. There are also specialized insurance policies covering dental care, vision needs such as glasses and eye exams and veterinary medical care for pets and livestock.
Businesses often purchase various types of insurance that individuals may not, such as errors and omissions liability insurance that covers damage from mistakes caused by a company and insurance covering the possibility of a key person dying or becoming disabled and unable to work. Medical practitioners and lawyers often carry malpractice insurance. Businesses may also buy insurance specific to their markets, such as a shipping company insuring the merchandise they transport and the vehicles, planes and ships they use to transport it.
When Insurance Is Mandatory
In some cases, the law may require a person or business to buy insurance. When that's the case, laws also sometimes make provisions to make sure that it is possible for everyone who needs such insurance to acquire it. Private contracts also often require that people or organizations carry insurance. For example, a business might require that its contractors carry insurance in case they damage something or get hurt on business premises, and mortgage lenders typically require borrowers to carry a minimum amount of homeowners insurance.
For example, many jurisdictions require drivers to carry a minimum amount of liability insurance in case they get in a crash that injures other people or damages their property. People who would otherwise have trouble acquiring car insurance because they represent too high a risk can be placed in what's called an assigned risk pool, where these customers are divided among the insurance companies in the area.
The U.S. Affordable Care Act, informally called Obamacare, also required most people to carry health insurance or pay a tax penalty. That provision has since been relaxed by Congress, but the law's provisions making it difficult for insurers to turn people away for pre-existing medical conditions remain on the books. Workers and their employers are also required to pay taxes that fund Medicare, the federal health insurance program for elderly and disabled people.
Businesses are also often required to carry worker's compensation insurance, which pays out if employees are injured or sickened on the job. This is regulated on the state level and the details vary from state to state.
The Government As Insurer
Different levels of government and corporations created by government sometimes act as an insurer. In some cases, this is done for greater efficiency, and in other cases, it's done to make insurance available that wouldn't be available through the private sector or to provide greater assurance to the public that the insurance coverage will be lasting and stable.
Medicare and Medicaid, a health insurance program for low-income Americans, are examples in the health sector. The government also provides health coverage to members of the military and to veterans. The federal government also runs the National Flood Insurance Program, which exists to provide affordable insurance against flood damage, a common risk that most private insurance policies don't cover.
On the financial side of things, the Federal Deposit Insurance Corporation covers bank account balances up to $250,000 against loss due to failures or financial struggles of banks. The FDIC also has a regulatory role in supervising banks, and it can take steps to make sure banks close down in an orderly fashion and move their deposits to other institutions so people don't lose money. It was created during the New Deal, under President Franklin Roosevelt, to restore faith in banks after many people lost their savings during bank failures during the Great Depression. The National Credit Union Administration provides similar coverage for members of credit unions, and some states also have their own deposit insurance programs for in-state banks.
Some states also administer their own workers' compensation programs, while others allow employers to purchase insurance from private carriers.
Self-Insurance and Captive Insurance
The term self-insurance refers to a person or company setting aside money to cover a particular risk. Some companies use self-insurance for health care coverage, meaning that they pay employee health claims directly rather than working with a third-party provider. This can be effective mostly for large employers, which can effectively spread risk across their employee pools as well as an insurance company could across a pool of insured customers.
Companies and individuals can self-insure against other types of risks, but in practice, it's often not practical to do so, since setting aside funds to insure a valuable asset like a building or car against damage or insuring against large liabilities can be difficult.
A related concept is captive insurance, where a company owns an actual insurance company that provides insurance to it, and formally pays the company premiums. This can be useful for tax and accounting purposes.
Mutual insurance companies are also technically owned by the people they insure, though they usually don't exercise direct governance of them. The relationship is similar to shareholders of a publicly traded company.
Insurance and Regulation
In the United States, insurance is typically regulated at the state level. States license insurers and require that they keep a minimum amount of capital on hand or appropriate reinsurance coverage to pay claims. They may also regulate how insurers can market their products to businesses and consumers. Most states have an insurance commission or a similar body to regulate insurers doing business within their borders
Health insurance is regulated at a mix of the state and federal level, particularly after the passing of the Affordable Care Act, which set new federal standards for health insurance.
When there are disputes between insurers and insured parties about whether a claim should be paid or how much should be paid, the disputes are often heard in state court. State insurance commissions may also get involved if it's believed the insurance company is doing something unscrupulous or illegal.
- Investopedia: Transfer of Risk
- MSN: Celebrities Who Insured Their Body Parts
- 21st Century Insurance: Understanding Car Insurance Deductibles
- Policy Genius: What Is a Per-Incident Deductible?
- Investopedia: Premium Income
- Purdue University: What is an Actuary?
- Business Insider: Here's How Warren Buffett Used Insurance to Become One of the World's Richest People
- Investopedia: Claims Adjuster
- The Motley Fool: What is Reinsurance?
- The Law Dictionary: What Are the Different Types of Insurance?
- FloodSmart: About
- Department of Labor: Workers' Compensation
- CoverWallet: State Workers Compensation Funds
- National Association of Insurance Commissioners: State Insurance Regulation