What Is Insurance — and How Does It Work?

What is insurance?

Insurance is a financial product that offers protection to pay for unanticipated losses. The types of losses your insurance will cover is laid out in a contract called an insurance policy, which also spells out how much you pay for your coverage.

Insurance is normally divided into two major categories:

• Property and casualty insurance, which focuses on risks that result in losses of property and possessions.
• Life and health insurance, offering protection from financial losses due to premature death or illness.

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Home insurance is an essential expense – one that can often be pricey. You can lower your monthly recurring expenses by finding a more economical alternative for home insurance.

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How does insurance work?

When you buy an insurance policy, you pay a fee called a premium. Your premium is determined through a process known as underwriting, where the insurer takes into account a number of factors to determine the risk that you'll file a claim.

For example, your auto insurance company will look at your age, location, vehicle type and even a version of your credit score. The greater the chances you'll have an accident and make a claim, according to the company's findings, the higher your premium will be.

Insurance companies pool together the premiums collected from you and other customers to make payouts when claims are filed. This is why you can pay a relatively small amount every month, every six months or every year, in exchange for knowing you'll be covered against big losses.

A deductible is the annual amount you’re responsible for paying out of your own pocket if you do file claims.

For example, if your auto insurance deductible is $500 and you have a loss of $10,000, you'd pay $500 and your insurer would cover the remaining $9,500. Damage worth less than $500 wouldn't be covered by your policy.

You can lower your premiums if you’re willing to accept higher deductibles and take on more of the risk yourself.

Types of insurance

There are plenty of insurance types that can offer you peace of mind, in many areas of your life. Here are some of the most popular insurance policies that cushion you from unexpected expenses:

Health insurance: Health coverage offers crucial protection from the enormous financial burden of a medical emergency or chronic disease.

Nearly half of Americans get health insurance through work, according to the Kaiser Family Foundation. But more than 10% of Americans didn’t have health insurance last year, the Centers for Disease Control and Prevention recently reported. That figure obviously doesn't include people who lost their jobs and health coverage due to COVID-19.

Health insurers typically offer a lot of choices, with combinations of deductibles and premiums — and copayments and coinsurance.

Copayments — or copays — are flat fees a patient must pay out of pocket for various services. For example, a doctor visit might cost you $20, or you might have to pay $10 toward the cost of a prescription.

Coinsurance is a percentage of your health care costs that you're required pay in addition to copays and after your deductible has been satisfied.

Life insurance: In a life insurance policy you make regular payments to the insurer, and, in exchange, the company pays out to your beneficiaries when you die.

There are two main types of life insurance: term life and permanent life. Term life covers you for a fixed amount of time (like 10, 15, 20 or 30 years), while permanent life insurance offers coverage through your entire life.

Auto insurance: In most states, having insurance is mandatory before you can drive. And while the states set their own requirements, typically the bare minimum you need is liability coverage, which pays out if you injure someone or damage another person's property.

Two other types of coverage included in many auto policies are: collision, which covers damage to your vehicle from accidents with other cars or objects; and comprehensive, which protects against theft, falling objects or animal damage.

Homeowners insurance: If you own a home, you need homeowners insurance — unless you have a bank account big enough to replace your home and all your belongings in case of a major loss.

When you're paying on a mortgage, your lender will require you to carry home insurance.

A standard policy insures your house and all the stuff inside in the event of a fire or other damaging event. In addition, you’re covered from liability if someone is hurt on your property. But read your policy carefully, because your insurance covers a lot of things — but not everything.

Renters insurance: Renters policies provides coverage similar to homeowners insurance, including to your personal property and for liability from some else's damages or injuries inside your apartment. A renter's policy also may cover additional living expenses, such as hotel bills, if the place you rent is left uninhabitable in a fire or other covered disaster.

Kiss your credit card debt goodbye

Millions of Americans are struggling to crawl out of debt in the face of record-high interest rates. A personal loan offers lower interest rates and fixed payments, making it a smart choice to consolidate high-interest credit card debt. It helps save money, simplifies payments, and accelerates debt payoff. Credible is a free online service that shows you the best lending options to pay off your credit card debt fast — and save a ton in interest.

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Your next steps

Understanding your coverage needs is just the start. As with any decision that affects your finances, you should research your insurance options thoroughly and shop around to get the best rates.

For help finding the right auto insurance for your budget, use a site that will show you quotes from multiple insurers so you can compare prices. Note that many insurers have been cutting their rates in 2020 as Americans drive less due to the coronavirus pandemic. Be sure to look into car insurance discounts, which can save you even more money.

Meanwhile, prices for home insurance are on the rise as natural disasters become more common and costly. When you're in the market for homeowners insurance, take time to gather competing rate quotes so you can find the most affordable coverage for your home.