Insurance and Risk

How Does Insurance Work?

The idea behind insurance is that you regularly pay a small amount for coverage and then, if something unexpected happens, the insurance company helps pay for the costs. This can protect you from unpredictable expenses from a car accident, healthcare, and many other things, depending on the type of insurance.

The monthly payment is called a premium (don’t worry, more on that later). Insurance companies create a pool of funds from the premiums their customers pay and use that money to pay for customer needs. Insurance works because many people share the risk of financial loss and reduce the financial impact of an emergency.

People who are considered a higher risk often pay higher premiums because they are more likely to use insurance money. Higher risk customers are those who’ve been in a lot of car accidents or live in an area with bad weather, to name two examples.

Types of Insurance

Different types of insurance cover lots of different things. Some of the most common include…

• Auto insurance: Insurance for vehicles as well as things that may be damaged with them, such as other cars or buildings.
• Homeowners insurance: Insurance for a house and can pay for any accidents in the home, like a kitchen fire or burst pipe, as well as damage from weather, like heavy snow. Other types of natural disasters, such as earthquakes or fires, may require specific insurance.
• Renters insurance: Insurance for an apartment, house, or other place that someone lives in but doesn’t own. Like homeowners insurance, this helps protect the home and any damages to the things inside it. Typically, the renter pays for renter’s insurance and the homeowner pays for homeowners insurance.
• Health insurance: Insurance that covers healthcare expenses. This includes regular doctor’s visits, surgeries, medicine, and more.
• Life insurance: Insurance pays a death benefit to someone’s survivors. If you died unexpectedly, life insurance can help pay for the funeral or make up for lost income.

Insurance Terms

Insurance uses a lot of unique terms that are important to understand.

• Claim: A request for the insurance company to pay for covered costs, such as a health care procedure, a damaged vehicle, or anything else the company covers.
• Deductible: The amount you pay before your insurance before your insurance starts paying for claims. Premiums and copays do not count toward your deductible.
• Out-of-pocket maximum: The maximum amount of money you’ll pay for care in a year. Premiums do not count toward your max.
• Policy: The agreement between you and the insurance company that includes everything you pay and what the company covers.
• Premium: A set amount you pay to your insurance company every month, even if you don’t ever file a claim to use the insurance.

Health, dental, and vision insurance are the most complicated types of insurance, with terms that are less common or don’t apply to other types of insurance.

• Copay: A set amount paid at the time of service for certain healthcare services, such as regular checkups and preventative care.
• Co-insurance: A set percentage of the full cost that you pay for a covered service. Co-insurance only applies after you meet your deductible. For example, you may owe 20% coinsurance after your deductible.
• In-Network Providers: A health care provider who has agreed to lower prices for anyone with your insurance.
• Out-of-network Providers: A provider who hasn’t agreed to lower prices, so you pay full price for any services.

Managing Risk

There are four strategies to manage risk: avoidance, reduction, retention, and transfer. Consider the example of driving to school on a snowy day.

If a driver has an auto insurance policy—which is legally required to be on the road—they transfer risk, or cost of a potential accident, to the insurance company.

A driver may avoid areas where lots of accidents happen, or practice avoidance by not driving at all and staying home instead of driving in the snow.

A driver could reduce risk by buying a car with a high safety rating and keeping the car up to date with safety checks. In the snow, the driver could reduce their risk by waiting until the roads are plowed to drive.

It’s possible to retain risk by choosing to go without insurance. On a snowy day, that’s particularly dangerous and a pretty bad idea. But risk retention can make sense in other circumstances. One example is cell phone insurance. If you break your phone, insurance would likely save you money on a replacement. But if you never need the insurance, you’ll pay extra money for nothing and on a device that you’ll replace eventually anyway. Because of this, risk retention has pros and cons.

Warranties & Extended Warranties

Extended warranties are another way to protect large purchases, but they may not always be worth the price. Many purchases come with a warranty, which is a promise from the manufacturer or seller to repair or replace the item if there’s something wrong with the way it was made within a set period of time. Warranties can make people more comfortable with big purchases, as they know the item is protected. Free warranties are often limited. If you want to protect the item for longer or expand coverage, you may have the option to purchase an extended warranty, either directly from the manufacturer, the retailer, or a specialized warranty company. It’s important to understand exactly what is covered and for how long when considering an extended warranty. Sometimes the cost is worth it, but other times, it isn’t. The cost of the warranty can usually be negotiated.

Purchases that typically offer an extended warranty include:

• HVAC Systems
• Major appliances like refrigerators, ovens, washing machines, and dryers
• Electronics like TVs, laptops, and cell phones
• Cars

Let’s look at a car as an example of the costs and benefits of an extended warranty. Cars are typically expensive to repair. An extended warranty could potentially cover some or all of these costs, making purchasing and maintaining a car more viable. It can also help keep a vehicle running well, and make it last longer by completing repairs that you might’ve skipped if required to pay for them outright. On the other hand, warranties are very specific about what they cover, and it's hard to know if a particular issue will be covered under your warranty. Some warranties also have deductibles, so you still pay at least some money out of pocket when you need to use the warranty. In fact, it’s estimated the majority of consumers who purchase an extended car warranty never actually use them.

Insurance is a vital way to protect yourself financially from all types of risk. By pooling money together with a large group of people, you’re sharing the risk of financial loss.