Insurance is a key piece of any comprehensive financial plan. That is why it is important to understand the basics of insurance and the many different types of insurance.
Owning insurance is about mitigating risk. No matter how careful we are in our daily activities and financial planning, there is always going to be some level of risk. Purchasing different types of insurance allows you to control how much risk you are exposed to.
Speed limits are commonly used as an analogy for risk and how insurance comes into play.
Suppose you live on a road where the posted speed limit is 35 mph. You and all of your neighbors would be at least a little bit safer if that speed limit was lowered to 10 mph, but at 10 mph it would take a lot longer to get out of your residential area. It would impact getting to and back from work. It would make trips to the grocery store take longer. Running errands would be more inconvenient.
Although 35 mph is a little bit less safe, it is a risk we are willing to tolerate because it allows us to get to places we need to go to a little faster.
At some point we will hit a limit for how much risk we can stomach. At that point, we look to insure the remaining risk involved. Using the speed limit example again, we have accepted there might be more traffic accidents at increased speeds. We purchase auto insurance to protect us in the event of being involved in an accident.
This is how insurance works. You pay your premiums to an insurance provider to cover your exposure to risk. If the thing you are insuring against should happen, the insurer pays you out some sort of claim or benefit.
You are paying a small fraction of what you would receive if the event you are insuring against happens. You have transferred the risk from yourself to the insurance company. The insurance company is able to pay out these benefits by making use of risk pooling.
RISK POOLING
Insurance companies operate by taking large groups of people exposed to a type of risk and grouping them together to cover losses, knowing that only a small number of those insured will ever actually incur a loss. In this way they are spreading out the risk in order to make a profit. Sometimes they even combine higher risk pools with lower risk ones to make them more viable.
For example, let’s say that on average in a given year 1 out of 100 drivers will be in an auto accident. By insuring 10,000 drivers, the insurance company knows that only 1% of those drivers are going to make a claim on a yearly basis, but they are collecting premiums from all 10,000.
When you look at male drivers between the ages of 16-22 lets say the number jumps to 15 out of 100 drivers will be in an accident. That is significantly more risk for the insurance company and could lead to a situation where the claims outpace the premiums collected.
To combat this, insurance companies will do two things. First, they will charge a higher premium to male drivers between the ages of 16-22 knowing that they are a higher risk. Second, they’ll combine these drivers with a safer pool of drivers. Perhaps female drivers between 35-50 are only in an accident at a rate of 1 out 500 per year. Insurance companies will offer this pool lower premiums to earn their business and by attracting these safer drivers they can counterbalance the higher risk demographic of males between 16-22.
Note, all of these numbers are made up. I did not research traffic statistics. I just wanted to give an overview of how insurance risk pools work.
Insurance companies have been around for a long time and have all kinds of data on the risks they insure. They know how likely most risks are, what the likely cost in payout for a risk event will be for them, and can adjust their pricing models accordingly.
TYPES OF RISK
Insurance companies have to deal primarily with three types of risk:
- Personal Risk – This is the risk of some kind of loss to you. You might become sick. You might die much sooner than expected, need a supplemental income later in life, or become unemployed. There are insurance products to address each of these types of risk.
- Liability Risk – This is the risk you impose to those around you. You might cause an accident in your car in which you hit another driver. Liability insurance covers losses that you are liable for.
- Property Risk – Property risk is risk to your property from damage or theft. If your house was damaged or destroyed by a violent storm, the insurance company should cover not just the storm damage and cost of repairing or rebuilding your home, but also additional costs endured as a result of the situation such as the cost for finding a place to live while the home is repaired.
TYPES OF INSURANCE
Insurance generally falls into one of three categories: life, health, and property.
Life insurance protects you (and your loved ones) against loss related to death. If you die while insured by a life insurance policy, the insurance company pays a specified death benefit to your beneficiary or beneficiaries. Life insurance serves as a means to replace lost income because of the death of a wage earner. It can also serve to meet the final expenses in the case of burial insurance.
- Term Life Insurance. Term life insurance is the most popular form of life insurance. With term life insurance a death benefit is paid out if the insured dies during the term of the policy. Some term life insurance policies cover a specific number of years. Twenty and twenty-five year policies are pretty common. Other policies cover up until the insured reaches a specific age.
- Whole Life Insurance. This is sometimes also referred to as “permanent” life insurance. Whole life pays a death benefit when the insured individual dies no matter how long they live. Whole life insurance includes whole life, universal life, and variable life.
Health insurance is for covering medical expenses. In addition to general health insurance policies there are specialized health insurance policies including supplemental, disability, long-term care, and dental insurance.
- Supplemental Insurance. This insurance is sometimes referred to as gap insurance. It covers the expenses above and beyond what your regular health insurance plan covers. The most popular form of supplemental insurance is Medicare supplemental insurance.
- Disability Insurance. This covers you in the case of a health issue that makes it impossible for you to work. Short-term disability insurance usually covers you for things like an injury while you rehab or recovery after surgery. Long-term disability insurance replaces a percentage of your pre-disability income after your short-term benefits expire.
- Long-Term Care Insurance. This type of insurance covers the expenses associated with assisted living either at home or in an assisted living facility.
- Dental Insurance. Some dental needs may be covered by your primary health insurance plan. For those that are not, dental insurance can fill in the gaps of what is not covered for routine checkups and cleanings or additional procedures.
Property Insurance covers property and possessions from damage and/or theft.
- Auto Insurance. This covers risks associated with owning a vehicle and driving. It typically covers both damages to your vehicle and damages that you may inflict on others with your vehicle.
- Homeowners Insurance. In addition to covering your home and its contents from damage and theft, homeowners insurance also provides liability coverage for anyone injured in your house or on your property.
- Renters Insurance. This type of policy covers your belonging when you are living in a rental home or apartment. In the event of damages to the rental, the landlord’s insurance covers the damage, but not your belongings. Like homeowners insurance it also covers liability for anyone injured while in the rental.
These are the major types of insurances available to us. There are additional types of insurance policies such as workers’ compensation, travel insurance, pet insurance, ID theft protection, and credit insurance.
This is just a basic overview of how insurance works and the types of insurance available. If you have more specific questions, I encourage you to speak with your insurance agent or financial advisor.
