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How insurance works

Insurance protects you from financial ruin

Life gives us many worries. The more responsibilities we have, the more worries we have. If my house burns down, how will I afford to rebuild it? If my son causes an automobile accident, how will I afford to pay the bills? If a hailstorm damages my car, how will I afford to repair it? What will happen to my family if I become unable to work? Who will provide for my family if I die?

For every worry we have, there are many, many people with the same worry. For most of them, the disasters they worry about will never happen. But disaster will strike a few of them. Insurance companies collect money from people with similar worries and use the money they collect to help the few. Insurance is intended to give us peace of mind by charging us for assuming the risk.

Policy holders pay insurance companies to assume risk for them. This means that your insurance company agrees to safeguard you against financial ruin for certain risks. Insurance companies are not banks; they are for-profit businesses. When disaster strikes, the insurance company helps you recover financially; if there is no disaster, the insurance company keeps your money to help someone else. This means that you agree to pay the insurance company, even if you don’t suffer from a disaster.

What insurance does when disaster strikes

You buy insurance so that you and your family will be able to pay your bills if the unthinkable happens. When disaster strikes, you report your losses to the insurance company and tell them what you lost. This is called “making a claim.”

Once the insurance company receives your claim, it will evaluate your request to determine whether it owes you any money and how much, according to the terms of your insurance policy. The person who does this evaluation work is called a “claims adjuster.”

Remember, when you buy an insurance policy, the insurance company is taking the risk that you will never use it. So, the more likely you are to make a claim, the more the company will charge you for taking the risk of insuring you. If your insurance company believes that you make too many claims, it may charge you a higher premium for insuring you.

An insurance policy is a contract

When you buy insurance, you get a “policy.” A policy is a legal contract that spells out what risks the insurance company is assuming for you and what risks it is not. The risks the insurance company is assuming are called “coverage.” The risks the insurance company will not assume for you are called “exclusions.”

Most insurance policies will ask you to take on some of the risk for covered items yourself. The more risk you are willing to assume for yourself, the lower your payments to the insurance company will be. The risk that you are willing to assume for yourself is called a “deductible.”  If you are willing to accept a high deductible, your insurance payments will be lower, but if disaster strikes, you will end up paying more of the costs yourself.

Payments to the insurance company are called “premiums.” Some policies call for premiums to be paid several times a year; some are paid once a year.

How to shop for insurance

Read your insurance policy completely

You need to read your policy and try to understand it — even if it seems complicated. You should contact your agent or your insurance company representative and ask questions about anything you do not understand. Questions to ask:

  • What is my coverage?
  • What risks are excluded?
  • How much will I pay in premiums every year?
  • How much will I pay if disaster strikes?
  • What is my deductible?
  • What should I do if disaster strikes?

How deductibles work

Let’s say you owned a car that is worth $15,000. If your car were totaled in an accident, and you did not have insurance, you would have to come up with the money for another car. (And, if you still owed payments on the car that had been totaled, you would have to continue to make payments, although your car had been destroyed.) If you had auto insurance, the insurance company would pay you $15,000.

However, if your insurance policy included a “deductible,” of, say, $500, you would be responsible for coming up with $500 out of your own pocket before the insurance company pays you. The higher the deductible in your insurance policy, the lower your premiums.

Usually, the deductible amount resets itself every year; sometimes it renews itself with every incident.

Let’s say your auto insurance deductible is $500 per year. If you are in an fender-bender this year that causes $3,000 worth of damage, you have to come up with $500 for repairs. If you are in another accident next year, your deductible is $500, even though you paid $500 last year.

Similarly, if your deductible is $500 per incident, this means that every time you are in an accident that causes over $500 worth of damage, you have to come up with $500 for repairs before the insurance company begins reimbursement.

It all comes down to how much risk you want to assume and how much you want the insurance company to assume for you. Your insurance agent can help you figure out what balance is right for you and your family.