As we accumulate assets and wealth, it then becomes important to protect ourselves from risks to what we’ve built up that we are not able to handle. Insurance provides protection against such unmanageable risks and is often a wise choice.  It’s important to understand what insurance we need and how insurance really works.

How Insurance Works

Learn about the various types of insurance in the market, what it protects, why you might need it, and how insurance all works. Our guide covers all forms of insurance in depth.

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The Purpose of Insurance

There are a lot of different insurance projects out there, with many different purposes, but the most fundamental reason to purchase and maintain insurance is to hedge against risk.

What insurance companies do is pool the risk from all their policyholders, creating a large fund where payments for covered events only represent a portion of what they take in. Thus they are able to bear these risks well.

The reason why it’s easier to get protection from insurance rather than looking to just prepare for these outcomes yourself is that it would take a certain amount of time, often a very long time, so save up enough money to cover the event from what you would be setting aside to pay the premiums.

While you are saving up for it, the event may occur, and you would be unable to bear the full financial burden. By purchasing insurance, you can receive the protection you seek right away, provided that you qualify and have the means to make the payments.

Insurance companies are able to do this since they collect premiums from many policyholders, and charge enough so that they can cover the claims that may arise at any point in time and still make a profit.

So when you buy insurance, you are paying a premium for this risk to be covered, and premium here means not what the payment is called, it’s a premium over and above the actual protection you receive, generally speaking at least. This premium is what it costs you for hiring a company to cover you, and otherwise there would be no incentive for private insurance companies to cover anyone, since they are in business to make a profit.

The competitive nature of the insurance business does serve to keep the profit margins of insurance companies reasonable, although a lot of people don’t really shop around much so this does serve to make the market less efficient, but those who do shop around can benefit from the best rates for what they are seeking to be covered with.

In the event of the need to make a claim, those insured against it will receive a substantial portion of the money needed to cover it provided to them, and therefore their financial obligations will be reduced to a more manageable level.

So this is what people buy insurance for, or at least what they should buy insurance for, and it’s important to keep in mind that the reason for this is to cover things and only things you can’t manage yourself, otherwise you aren’t getting enough value for the additional costs of paying someone to cover you, including both administrative costs and profit margins.

Examples of Things That Are Covered By Insurance

Practically everyone has had an experience with insurance, as it plays a big role in just about everyone’s life. If you drive a car for instance, most jurisdictions will require you to carry a minimum amount of insurance to cover the harms that you may be responsible for while driving.

The goal with this is to ensure that others are reasonably compensated for damage that you do to their property and their persons, as well as any damage you may do to public property. It is not seen as fair that others, including taxpayers, should be responsible for bearing the cost of damage you cause, either intentionally, through negligence, or by accident.

So if you hit someone else’s car and it is deemed to be your fault, you may not have the means to fix or replace the other vehicle, or compensate the other parties for their injuries. So this is a case where it is necessary in order to protect yourself financially to purchase insurance.

One may also want to ensure their own vehicles against loss and damage, and if one gets a secured loan for it, this is usually required by the lender, just as home insurance is required to get a mortgage, as the banks don’t want to suffer financially by your ill fate.

Protecting your other personal property is another big reason people insure, and if your home burns down for instance, people just don’t generally have the money to replace it, or if they do, it very often would represent a great financial burden. If one was wealthy enough that they could easily handle, or prefer to handle such losses, there wouldn’t be a need for insurance, and one’s ability to handle these events is a fundamental consideration in fact.

In some countries, such as the United States, you are on your own for the most part when it comes to medical coverage. These costs can easily wipe out one’s entire assets, and the costs can run into the millions, and this is not something that a lot of people can or would want to bear on their own.

Health insurance can also be bought to cover things such as the need for long term care, should one not be able to care for themselves, and there is no other option but to hire someone or go into a care facility. There is even health insurance for pets, and even though one may be able to afford the sometimes very expensive costs involved, one may prefer to keep those funds for their original purpose, such as retirement savings.

If one has people who are financially dependent upon their income for their well being, and this is very often the case to some degree or another, life insurance policies can provide for loved ones in the event of your death, where your income ceases of course.

Should one become disabled and unable to work, this will result in a loss of income, and while the government may provide benefits to some degree, the disability may not be seen as serious enough to qualify, or the benefits may not be of a sufficient amount. Unless one has enough savings to get them through, and people usually don’t, disability insurance may be worth considering.

Deciding On The Need and Extent of Insurance Coverage

If you talk to a person who makes their living selling insurance, they of course will be motivated to sell you as much insurance as they can, so it pays to have a good idea whether or not a particular type of coverage is wise or suits your needs enough.

Some people buy insurance policies on their kids for instance, even though there is no income to protect, and this is the main reason why people buy life insurance, to ensure that those depending on the income of the person get taken care of properly when the person’s income disappears upon death.

There’s nothing stopping people from doing such things, but the risk of a child dying is very low generally, and the costs involved, burial costs, aren’t that great. It may be the case that the parents would be better served putting the cost of the premiums away in a savings vehicle for the kids instead, especially if there is a tax advantage involved.

So we generally need for the financial burden that is created by the loss you’re looking to insure against to be great enough to make it worth the cost. There are some for instance who purchase supplemental health insurance that only protects them against events that don’t cost much at all, incidental expenses like eye care and prescription drugs, with frequent claims, and they could have just paid the amounts out of pocket and saved money.

The degree of risk is another consideration. Buying insurance or not buying insurance is a sort of gamble, and if the odds are small enough, it may not be worth protecting against. An example would be kidnapping insurance, and if you live in an area where kidnapping is rare, or you just don’t have enough wealth that anyone would ask a ransom, then this just isn’t anything that may be worth considering.

On the other hand, there are people who travel to countries where kidnapping is a much higher risk event, and it may be wise for them to buy this coverage, if they or their employer has the means to pay it and may suffer very large financial losses, or if they just want to buy peace of mind.

Peace of mind is another big potential benefit of insurance, as this can eliminate the need to worry about certain things happening, provided one buys coverage against them. This can improve their quality of life quite a bit and is something that needs to be factored into the decision to insure or not.

If one is worried about something, that alone can be a good enough reason to buy insurance, as this can really tip the scale, and there are some financial benefits that are involved as well.

Life is full of risks, and a lot of the risks we face cannot be efficiently covered properly on our own, if they can even be covered at all. There are companies out there who can assist with this risk management, taking it on themselves for a fee. Due to the fact that they have much vaster resources than we do, they are able to bear the risk when we are not.