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How Does Insurance Work?

Posted on July 15, 2012 by

You know you need it, but how does insurance actually work?

Insurance makes the world a cheaper, less-stressful place.  If it wasn’t for insurance, we’d have to worry about suffering a financial catastrophe at every turn, and we’d be charged high prices by businesses fearful of the same.

For a relatively low price, insurance companies protect people against costly risks, such as unexpected injuries and car accidents.  If the unexpected occurs, the insurance company covers the person’s costs (at least to an extent… maybe).

Insurance, whether health, homeowner’s, or auto, is purchased in policies.  While all insurance policies function the same, they vary widely in their details.  Some policies are far better than others.  Here are the basics:

Components of an Insurance Policy

All insurance policies have five main parts.  The details of these parts will vary, depending on what kind of policy you get.  The five parts are: (1) premiums, (2) co-pays, (3) deductibles, (4) policy coverage and limits, and (5) claims procedures.

  • Premiums – Premiums are your monthly or yearly payments, which you need to pay for coverage.  If you don’t pay the premium, your policy can be cancelled. Paying entire premiums up front is marginally cheaper. For example, a health insurance policy might cost $200 a month or $2200 a year.
  • Co-Pays – Co-pays establish the percentage of your costs that your policy covers. For example, if you have a bill covered by a health insurance policy with an 80/20 co-pay, your insurer will pay 80% of the bill, and you will pay the other 20%.
  • Deductibles – Deductibles are the amount of money you need to pay out of pocket before your policy kicks in. So, if you have a health insurance policy with a $1,000 deductible, you need to pay $1,000 before your insurance company begins to cover you.
  • Coverage/Limits – Insurance policies are riddled with restrictions and exceptions. Some don’t cover hospital visits. Others don’t cover accidents with uninsured motorists.  Make sure you understand what you’re covered for and what limits apply to your policy.  A website like this can’t answer that for you.
  • Claims – You might need to pay the costs up front, then bill your insurance company by filing an insurance claim.  Essentially a claim is a document saying, “under my policy, you owe me $X for — bill.”  You will need to follow particular procedures to file a claim.

Factors That Affect the Price of Insurance Policies

Insurance companies are out to earn a fat dollar for themselves.  If they charge low premiums and have to cover many expensive claims, they’ll lose money.  So, they often charge higher premiums to people who meet one or more risk factors — factors that indicate they will have more frequent, expensive claims.  Factors include:

    • Driving record
    • Home location (state, city, neighborhood)
    • Existing health issues
    • Age
    • Value of the property covered (Miata < Mustang)
    • Lifestyle (smoking, lots of driving, manual labor)
    • Whether you’re in a group plan (often through an employer)

How to Buy Insurance

When buying insurance, you should buy the best policy you can afford.  It might seem like a waste of money to pay $300 a month on health insurance, but if you can afford it, it can be well worth the money.

For example, a $200 policy might come with a 60/40 co-pay, while a $300 policy might have a 90/10 co-pay.  If you end up in the hospital for a tragic reason and rack up a $50,000 medical bill, the $300 policy will cover $15,000 more than the $200 policy.

When looking for an insurance policy, you want to shop around.  Unlike utility companies, there are a ton of insurance companies out there.  No matter what type of coverage you’re looking for, you have will many policy options.  Make sure to talk to a number of companies with the basic goal of trying to get the most protection for the cheapest price (duh, right? Well, it can be tough when you factor in all the different parts of a policy).

Common Types of Insurance

Insurance can apply to anything.  You can insure a hamster for the right price.  However, the most common types of insurance include:

If you’re moving, mover’s insurance should be on the top of your mind.