Insurance is a form of risk management, usually via a contractual arrangement under which one party pays another, the insurer, to take on a risk and make specified payments should that risk come to pass during the term of the contract. There may be other parties to the arrangement, such as a beneficiary to receive the payments that is different from the insured party. Insurers themselves may pass on some portion of the risk to another insurance company, known as a reinsurer. The contract is often called an insurance policy.
In life insurance, the primary risk being managed is the risk of death of a specific person. If an employer purchases life insurance for all of its employees as an employee benefit then the employer would own the contract, each employee would be an insured person, and each employee would be able to specify the beneficiary in their case, while the insurance company is the fourth party. That insurance company might also enter into a reinsurance policy to protect it from the risk of a single event killing many of the employees of the contract holding company. In the reinsurance contract, the original insurer would own the contract, be the insured party, and be the beneficiary, while the second insurance company would be the insurer.
When to insure
In general, you should seek insurance when you have a real risk of loss to be avoided, the ability to pay for insurance, but not the ability to self-insure.
Risks to insure
- Also see examples of specific insurance types below at Types of Insurance.
While almost any risk can be insured via specialty insurers, broadly speaking there are two main types of risk insured. The first is risk of harms directly to the insured party or their family and the second is the risk of incurring liability for harming someone else and thus having to pay them for the harm done.
Risks of harms to yourself and family
There are three main types of risk to yourself and your family: damage to property, loss of income, and unexpected expenses.
Risk of loss to your own property is, in general, the easiest type of risk to self insure, as the amounts in question are limited to either the value of the property or the cost of replacing it. It may also be quite possible to self insure for a small loss (e.g. a broken window) but need coverage for a large loss (e.g. the house burns to the ground), so such insurance policies generally are available with deductibles. You may be able to self insure small amounts simply by planning on lowering other expenses to cover the loss.
Risk of loss of income, whether that income is measured in dollars or not, tend to change meaningfully with your current income, your family status, and your savings and net worth. This is harder to self insure, because if the risk comes to pass income is lost and expenses may also rise at the same time. In general, as your annual income rises this risk rises, and as you get closer to retirement this risk lowers. For Americans overall, both tend to happen at the same time. The risk to your family from losing your income varies with family status. As your savings and net worth rise, they produce more and more income and thus reduce the risks associated with employment income.
Risk of unexpected expenses is the risk of having to spend money that might not be available and wasn't planned for. Medical expenses are an obvious example, but if a homemaking spouse dies or becomes disabled then childcare and other expenses may occur unexpectedly.
Risks of harming others
Risk of incurring liability to others by harming them varies based on your activities and profession. For examples, an auto driver has higher risks than someone who only uses public transportation, and a self-employed professional has higher risks than an assembly line worker. The amount of potential loss tends also to vary with your net worth and income; the more you own and earn the more that might be lost or need to be paid in the future.
In general, an insurance company makes its money from two main sources. The first is the difference between the premiums paid for insurance policies and the amounts it pays out under the contracts, also known as the profit from underwriting. Because the payouts come after the premiums are paid, sometimes years later, it also has had for some time the use of the money paid out. This money that the insurance company has the use of is its float, which can be and is invested. The return on investment of the float is the second main source of income. Against these two sources of income the company needs to pay its administrative expenses and to generate profits for its owners.
Because the insurance company needs to pay administrative expenses and generate profits, when an individual can do so they are generally better off self-insuring than purchasing an insurance policy. By self-insuring, you get to keep the investment returns on the floated amounts, the profit that the insurance company will make, and the administrative costs of the insurance company. This requires both having saved enough money to cover the potential loss from the risk and the discipline to keep that money saved unless the risk materializes. Both are easier to manage for small amounts than large amounts. Thus, in auto insurance it is usually easier to self-insure for the risk of damage to your own vehicle (no more than the cost of a new car) than for the risk of causing damage to other people and having to pay their medical expenses (an amount that could be very, very high).
Deductibles are terms in an insurance contract allowing the insured party to self-insure for small amounts of loss while having insurance protection against large losses. Because a deductible keeps the first dollars of loss with the insured party, they have a relatively large effect on the premium to be paid for an insurance policy, and are a potential source of savings on insurance costs. For a disciplined saver, the amount that they can self-insure will rise over time, and thus deductibles in existing policies should be reviewed periodically to see if it would make sense to increase the deductible and lower the premium for future years.
Purchasers of insurance should review existing coverage periodically and when there is a major life event. Changes in your family, major changes in employment or compensation, and purchases and sales of insured property are all events that should trigger a review of applicable insurance.
Types of insurance
As discussed above, there are different types of risk. Some types of insurance are for one risk only, while others combine coverage of different types of risk based on the source of the risk. Below are some types of insurance coverage that individuals commonly have:
- Auto insurance often covers both risks of property damage and needed medical care as a result of an incident involving a car. In most places, some degree of coverage is required by law in order to drive a car. Deductibles are usually available, and amounts and types of coverage are often highly customizable beyond the legally required minimum.
- Deposit insurance covers the risk of loss of money on deposit with a financial institution due to the failure of that financial institution. It is usually provided by a government agency to all holders of certain types of account, up to pre-specified limits, not purchased directly by individuals. The cost of this insurance is charged directly to the financial institutions, which build it into the cost of their products.
- Health insurance comes in many kinds, including dental insurance. In the U.S., most people with health insurance have either group insurance through an employer or family member's employer or government insurance, though individually purchased health insurance plans are also available. In other countries, basic health insurance may or may not be provided by the government for all residents and supplemental privately purchased insurance may or may not be either legal or readily available. Generally speaking, it covers only the cost of providing medical care to specific covered individuals, may have deductibles.
- Homeowner's insurance, renter's insurance, and landlord's insurance generally provide coverage for loss of one's own property and liability to others occurred because of their presence on your property. Deductibles are usually available. While a homeowner is paying off a mortgage on their house the lender will usually require homeowner's insurance, as may a buyer during the process of selling the house. There are always excluded perils, which means that if the loss is caused by one of those items then the insurance provides no coverage. There may be ways to cover these exclusions, either by riders amending the standard policy for an additional fee or by purchasing specialty insurance such as earthquake or flood insurance.
- Life insurance provides money for the beneficiary upon the death of the insured person. Individuals may have it to ensure the well-being of their family in the event of untimely death or to provide liquidity or bequests as part of their estate plan. Deductibles are usually not available. The most common forms are term insurance that is in force for only a period of time and the more expensive whole life insurance that combines the features of life insurance with those of a sub-par investment vehicle. Generally speaking, you are better off purchasing term insurance and using a good investment vehicle than purchasing whole life insurance, but it does have a place in estate planning in certain situations. Accidental death and dismemberment insurance may be offered as a supplemental employee benefit; it pays additional amounts above life insurance if the covered person dies or loses body parts.
- Private mortgage insurance and credit insurance are forms of insurance that are rarely of value to the purchaser, but may be required by a lender. They protect the lender from potential losses and are paid for by the borrower. Generally speaking, you should avoid these whenever possible, and if required to have them then remove them at the first possible date.
- Professional insurance may take many names, depending on the profession, such as malpractice insurance or errors and omissions insurance but protects the professional from paying directly for losses caused to their clients, and potentially others, by their work.
- Title insurance protects against the loss of property - usually land and buildings - due to flaws in the chain of prior ownership. It is usually obtained at the same time as either the property is purchased or mortgaged. There are two forms: one that protects the lender on a mortgaged property and a second that protects the purchaser of a property. Lenders often require the form that protects them, and the form protecting the purchaser may also be available at that time at no or limited additional cost.
- Umbrella insurance provides additional liability insurance above and beyond that contained in your other insurance policies. Umbrella insurance will generally need to be coordinated with the liability limits under those other policies.
- Worker's compensation insurance and disability insurance collectively provide coverage for loss of the ability to work and gain income due to accident, injury, or illness. Disability insurance generally covers losing this ability because of something happening outside the workplace, and can be available either from the employer as a benefit or by individual purchase. Workers comp insurance usually must be provided by the employer and covers both losses caused by the conditions of work and the medical care costs of a workplace incident.
Insurance company ratings
Free access to the ratings database, along with some general insurance information, can be found here: A.M. Best's Consumer Insurance Information Center. Access the search engine from the right-side menu "AMB Credit Reports" Search icon.
C.L.U.E. (Comprehensive Loss Underwriting Exchange) is a claims history database created by ChoicePoint that enables insurance companies to access consumer claims information when they are underwriting or rating an insurance policy.
The report contains consumer claim information provided by insurance companies. It includes policy information such as name, date of birth, and policy number, claim information such as date of loss, type of loss and amounts paid, and a description of the property covered. For homeowner’s coverage, the report includes the property address, and for auto coverage, it includes specific vehicle information.
The database contains up to 7 years of personal property claims history.
Free annual report
The Fair and Accurate Credit Transactions Act (FACT Act) was enacted in 2003 and amends the Fair Credit Reporting Act (FCRA), a federal law that regulates, in part, who is permitted to access your consumer report information and how it can be used. The FACT Act entitles consumers to obtain one free copy of his/her consumer file from certain consumer reporting agencies during each 12-month period.
LexisNexis® Risk Solutions has companies that maintain consumer files that are subject to the free disclosure requirement: C.L.U.E. Inc. maintains information on insurance claims histories and LexisNexis Screening Solutions Inc. maintains employment history and resident history information. These companies designed an easy process for consumers to request their free file disclosure.
Free personal property (homeowners) and auto insurance reports are available from: C.L.U.E.® Report
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