How Insurance Works

Insurance is something you buy hoping you never have to use. You purchase it to protect yourself from unexpected losses you can't afford—the accident you hope you never get into, the fire you pray never destroys your home, the hailstorm you know sooner or later is bound to batter your roof, the lawsuit that threatens to wipe out all your savings.

So, it's no mystery as to why most people don't even want to think about their insurance, let alone take the time to understand how it works. But, most people do want to have at least enough information to be on a level playing field with their insurance company, especially when they need insurance the most—when it comes time to file a claim.

Insurance Isn't a Bank Account

U.S. consumers spent $652.8 billion on homeowners, auto and business insurance in 2020, according to Insurance Information Institue. That's a lot of money to spend on something when you have only a vague idea of what you're getting! But, part of the problem is that insurance doesn't work like other products or financial services that we pay for.

Many people make the mistake of thinking their insurance works like a bank account—money in, money out with interest when they need it. Insurance is about spreading out the risk among everyone who buys insurance from your same insurance company. Your premium goes to help fund losses suffered by the entire group. As a pooled resource, you can cover the larger losses suffered by individuals. Your company works for you by trying to minimize the amount of risk.

Your Insurance Policy is a Legal Contract

An insurance policy is a legal contract between you and your insurance company. Like all legal documents, it very clearly spells out certain conditions that you both agree to when you sign off on the paper work. You agree to pay the premium and your company agrees to cover you for certain losses. Forms may differ from company to company, but all will include what is covered and what isn't covered by your insurance. There is a limit to the amount any insurance policy will pay for a loss and no policy covers every type of loss. If there is a potential risk that concerns you and it isn't referred to in your policy, ask your agent or company representative if it is covered by your general policy and if special coverage is available.

Factors that Impact Cost

Insurance companies are like other businesses, in that, the price charged for the product is directly related to the cost of "raw materials" used in the product. If the price of beef or bread goes up, then the price of hamburgers must also rise. Similarly, if the price of car repairs, home construction or settling lawsuits rises, the cost of auto, homeowners or liability insurance must also rise.

But, insurance companies have little direct control over the risk factors that affect the amount of claims they pay out. To hold down costs it's essential to hold down the costs of what insurance pays for. That's why the insurance industry devotes considerable resources to supporting programs and proposals that reduce losses, prevent injuries and save lives.

Why do different insurance company charge different rates?
An insurance company sets prices partly on its own past experience with claims that are filed (for example: accidents involving certain types drivers in certain kinds of vehicles) and on competition in the marketplace. One particular company may have a much better experience insuring a certain type of driver than the industry does as a whole.

What about reducing insurance company profits?
Contrary to popular belief, insurance isn't a very profitable business. Many companies write insurance, particularly homeowners insurance on a loss and make money only on their investment income. The average profit margin is 10% lower than the median Fortune 500 Company. The real cost of insurance is only known after claims are made and paid. No one can know for sure when the coverage is first sold just how much of that premium will or will not be left for profit after claims are paid. The financial viability of your insurance company should be an important part of your decision in choosing to stake your future with theirs.

What should I look for in an insurance company or agent?
Agents and companies are there to help you. At the most basic level, any agent or company representative should be able to answer all of your questions about insurance, provide you a thorough assessment of your insurance needs, and offer you a choice of insurance products to meet those needs. Also, any insurance agency or company should provide you with prompt, quality service in the case of a claim. (Ask questions like, do they provide 24-hour claims service.)

Just as important is the level of professional confidence and personal comfort you feel with the company representative or agent.

An often overlooked factor to keep in mind is that there are two kinds of insurance agents and two kinds of insurance companies. There are companies who sell insurance directly to you and there are companies who sell insurance through agents. There are also two different kinds of agents: those who represent one insurance company and those who represent more than one insurance company.

Agents offering the policies of one insurance company through their agencies are often referred to as "captive agents." Agents offering the policies of more than one insurance company (but limited to companies who sell through independents) through their agencies are called "independent agents." You should do a through self-evaluation of what your insurance needs are and select a company that best fits YOU!