Insurance is a form of risk management, usually via a contractual arrangement (an insurance policy) under which one party pays another, the insurer, to take on a risk and make specified payments if that risk manifests during the term of the contract. There may be other parties to the arrangement, such as a beneficiary who receives the payments, different from the insured party.
Insurers may pass on some part of the risk to another insurance company, known as a reinsurer.
For example, life insurance primarily manages the risk of a person's death. If an employer purchases life insurance for its employees, as an employee benefit, then the employer owns the contract, each employee would be an insured person, and each can specify their beneficiary, 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 covered employees. 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, use insurance when you want to avoid a real risk of loss, and you can pay for insurance but you cannot "self insure" (that is, you cannot cover the loss yourself).
Risks to insure
While you can insure against almost any risk through specialty insurers, broadly speaking there are two main types of risk to insure against. The first is risk of harms directly to you or your family, and the second is the risk of liability for harming someone else, and so having to pay them for the harm done.
Also, see Types of insurance below.
Risks of harms to yourself and family
There are three main types of risk to you and your family: damage to property, loss of income, and unexpected expenses.
- Generally, risk of loss to your own property is the easiest type of risk to self insure, as amounts 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 (for example, a broken window) but need coverage for a large loss (for example, your house burns to the ground), so these insurance policies usually have 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 changes with your current income, your family status, and your savings and net worth. This is harder to self insure, because if the risk manifests, then you not only lose income, but your 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 also varies depending on your family situation. Finally, as your savings and net worth rise, they generate more income, and this reduces the risk of losing your employment income.
- Risk of unexpected expenses is the risk of having to spend money that might not be available and was not planned for. Medical expenses are an obvious example, but if a spouse dies or becomes disabled then you might face unexpected childcare or other expenses.
Risks of harming others
Your risk of incurring liability to others by harming them varies based on your activities and profession. For examples, a car driver has higher risks than someone who only uses public transport, and a self-employed professional has higher risks than an assembly line worker. The potential loss varies with your net worth and income; the more you own and earn, the more that you might lose or need to pay in the future.
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 use of the money in the interim.
The money that the insurance company holds is its float, and the company will invest it. The return on this investment is the second main source of income. The company uses this income to pay its administrative expenses and to generate profits for its owners.
Because of these administrative and profit overheads, it can be better to self-insure than to purchase 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. To do this, you need to have enough saved money to cover the potential loss from the risk, and the discipline to keep that money saved in case the risk materializes.
Both are easier to manage for small amounts than large amounts. For example, with 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 extremely high).
Deductibles are insurance contract terms that let the insured party self-insure for small amounts of loss while having insurance protection against large losses. Because deductibles place the first dollars of loss on the insured party, they have a relatively large effect on the insurance policy premium. This makes them a useful insurance cost saving.
For a disciplined saver, the amount that they can self-insure will rise over time. Review existing policy deductibles periodically, to see if it would make sense to increase the deductible and lower the future premiums.
Where you have insurance, review existing coverage both periodically and on a major life event. Changes in your family, major changes in employment or compensation, and purchases and sales of insured property are all things that should trigger a review of 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 common types of insurance coverage.
Auto insurance usually covers both risks of property damage and needed medical care as a result of an incident involving a car. In most places, local laws require some minimum level of coverage 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 losing money due to the failure of a financial institution. Government agencies usually provide it to all holders of certain types of account, up to pre-specified limits. Individual investors do not purchase it directly. Instead, the government agency charges the financial institutions directly for insurance cost, and these companies include this in the cost of their products.
Directors and Officers (D&O) insurance
Directors and Officers (D&O) insurance covers any liabilities that come from serving on a board of directors for an HOA, company, non-profit, and so on.
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, although individually purchased health insurance plans are also available.
In other countries, the government may or may not provide basic health insurance for all residents, and supplemental privately purchased insurance may or may not be either legal or readily available.
Generally speaking, health insurance covers only the cost of providing medical care to specific covered individuals. It may have deductibles.
Homeowner's, renter's, and landlord's insurance
Homeowner's insurance, renter's insurance, and landlord's insurance cover you for loss of your own property, and for liability to others incurred 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 on the death of the insured person. It ensures the well-being of family members in the event of untimely death, and provides liquidity or bequests as part of an 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.
Rather than purchasing life insurance, you may be better off purchasing term insurance and using a good investment vehicle, but life insurance does have a place in certain estate planning situations. An employer may offer accidental death and dismemberment insurance as a supplemental employee benefit. This pays additional amounts above life insurance if you die or suffer serious injury.
Private mortgage insurance and credit insurance
Private mortgage insurance and credit insurance are rarely of value to the purchaser, but which a lender may be require. They protect the lender from potential losses but the borrower pays the premiums. As a rule you should avoid these whenever possible. If you are required to have them, remove them at the earliest possible date.
Professional insurance has many names, depending on the profession. For example, 'malpractice insurance' and 'errors and omissions insurance'. It 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, because of flaws in the chain of prior ownership. You would usually take it out when you buy or mortgage a property. It has two forms, one that protects the lender on a mortgaged property, and one that protects the purchaser of a property. Lenders often require the form that protects them. The one that protects 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. If you use it, you will normally need to coordinate umbrella insurance with the liability limits under your other policies.
Worker's compensation and disability insurance
Disability insurance usually covers losing this ability because of something happening outside the workplace, and your employer may offer it, or you can purchase it individually. An employer must usually provide workers comp insurance; this covers both losses caused by the conditions of work and the medical care costs of a workplace incident.
Insurance company ratings
You can find free access to the ratings database, along with some general insurance information, 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 lets insurance companies 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 seven years of personal property claims history.
Free annual report
The Fair and Accurate Credit Transactions Act (FACT Act) was enacted in 2003. It 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 one free copy of their consumer file from certain consumer reporting agencies every twelve months.
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
- Enable browser cookies
- Do not use gmail's '+' suffix to track the email, for example
account+LexisNexis@gmail.com, or the account login will fail. Standard email formats only, for example
- The reports are good for 30 days online. If you do not print the report, save the web page to a file. Because it contains personal information, make sure it is stored securely.
- Moody's Investors Service, Fitch, and Standard & Poor's Ratings Services are 3 of several credit rating agencies categorized as a Nationally Recognized Statistical Rating Organization (NRSRO) by the SEC. The SEC's Office of Credit Ratings maintains a list here: Office of Credit Ratings
- On March 29, 2011, AM Best furnished to the Commission on Form NRSRO a notice of withdrawal from registration in the category of financial institutions. (SEC News Digest, June 10, 2011)