Insurance Basics: Everything you need to know

How Does Insurance Coverage Work?

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Insurance is a critical subject to understand for full financial literacy. There are many different kinds of insurance available to serve different purposes.

Getting insurance is about mitigating risk. No matter how hard we try, we will always have some level of risk in our activities. We collectively and individually decide how much risk we are willing to tolerate.

For instance, you might live in a neighborhood with a speed limit of 25 miles per hour. Everyone would be a bit safer if we lowered that speed limit to 5 miles per hour, but at that speed, it would take too long to get out of the neighborhood and everyone’s quality of life would suffer. So we agree to a 25 mph limit that is a little bit less safe but helps everyone be more productive and get where they’re going.

When we reach the limit to how much we’re willing to spend or sacrifice to avoid risk, then we need insurance against the risk that remains. We’ve all accepted there might be more traffic accidents at the speed limit we have, so now we get auto insurance in the event an accident does happen.

This is how every different kind of insurance works. You pay a premium to an insurer to cover any risks you can’t eliminate some other way. If the thing you’re insuring against should happen, the insurer pays a claim to you.

Typically, you pay far less than the claim would be. You might pay $100 per month for car insurance, but it could cost over $30,000 to replace your car if it is stolen or totaled. The insurance company is able to pay out these amounts by engaging in something called risk pooling.

Risk pooling

Insurance companies group large numbers of people together to cover losses. Only a very small fraction of those insured people will have a loss, so the risk is spread out among them. In a large city, half a million people might use the same insurance company, but very few of them will have a car accident or stolen car and need to file a claim. By pooling the risk, there is plenty of money available to pay the small number of claims.

Risk pooling also pools risks over time as well as over individuals. An earthquake might strike and damage a lot of cars at once. Since that doesn’t happen very often, insurance companies can prepare for disasters by spreading the risk over several years.

Insurance companies have been around long enough to know how likely most risks are. But some activities are hard to predict—terrorist bombings can cause a lot of damage, and there’s no way to know how likely these attacks will be. Insurers also face the challenge of asymmetric information.

Asymmetric Information

Asymmetric information is a term from economics that means one party has more knowledge than the other. If I’m selling you my car, and I know the transmission is going bad but you don’t, I will be able to charge much more for the vehicle. In the stock market, an investor might know secret information about a company—they’re about to be acquired by another company, or they are struggling financially—and buys or sells stock based on that information. This is commonly known as “insider trading” and has landed a few high-profile individuals in prison.

Adverse Selection

Asymmetric information leads to adverse selection for insurers. If you know you have a serious health condition but the insurance company doesn’t know that you will get health insurance far cheaper. If the insurance company lets too many people buy insurance this way, it will lose money and go out of business.

A common issue for health insurance providers is smoking. Smokers will be more expensive in terms of health care, so insurance companies want to limit how many smokers they insure, or charge those who smoke more. A smoker might lie on the insurance forms to get a cheaper rate, but the insurance company is facing adverse selection here and will lose money.

This is one of the biggest challenges insurance companies face. How can they price their service so everyone who needs it will buy it? If they charge enough for health insurance to cover all smokers, it will be too expensive for non-smokers. If they charge everyone the non-smoking rate, they will go out of business. The solution is to charge everyone differently based on their risk.

Moral Hazard

Moral hazard is related to risk. If we push the cost of one person’s risk onto someone else or pool that risk with others, we make the risky behavior less expensive for the individual.

This can lead people to take more risks than they might otherwise. Drivers who have to bear the cost of an accident themselves might drive much more carefully. But since everyone who drives must have auto insurance, they might feel comfortable driving more aggressively, knowing insurance will cover any damage if they have an accident.

We saw this in the mortgage market—subprime lenders could create a home loan with a borrower who may have been more unlikely to be able to repay. Then the loan was sold to another mortgage company. Now the broker who wrote the original loan was safe— they made their money, regardless of whether the loan had to be foreclosed on later. There was effectively no risk to the original mortgage company.

Insurance can lead to moral hazards in lots of ways. You should always carefully lock your car, but if you have insurance, you know it’s covered, so you might not double-check the locks or be careful where you park.

Insurance companies charge deductibles, where you have to pay some part of the claim. You might pay the first $500 toward repairing damage or theft. Since this portion comes out of your pocket, you are less likely to take extra risks. This is a major way insurance companies combat moral hazards.

Types of risks

Insurers have to contend with several different types of risks.

• Personal risk is the threat of some kind of loss to you. You might get sick, die prematurely, or grow old and need supplemental income. There are insurance products for all of these risks. Even becoming unemployed is a personal risk that people are insured against.
• Liability risk is a risk you pose to others. You might hit someone with your car, or your dog might bite someone. You would need insurance to cover losses you are liable for.
• Property risk is the risk to your property, whether from theft, or damage. If your house burns in a fire, your insurance should cover not just the damage done directly by the fire, but indirect costs as well, like securing a place to live while your home is repaired or rebuilt.

Risks to you and everyone, like a flood or volcano, are called fundamental risks. Risks just to you, like burglary or a single-house fire, are called particular risks.

Types of insurance

Property Insurance:

• Auto insurance covers the risks of driving and car ownership. It typically includes liability insurance and property insurance.
• Homeowners insurance covers your home and its contents against damage and theft and liability for anyone injured on your property. Typically it won’t cover disasters like floods; this coverage must be added on with a separate policy or rider.
  • A rider is an add-on that covers specific things at an extra cost. You might own rare collectible items that are difficult to place a value on. The famous inverted “Jenny” postage stamp from 1918 has a face value of 24 cents but is worth over $250,000. You would not want that insured for 24 cents! A rider would specify it is insured for the full $200,000, and your insurance company would charge you a bit extra to cover it.
  • Check out this guide to homeowners insurance.
• Renter’s insurance covers your belongings in a rented house or apartment. Your landlord’s insurance will cover the home in the event of a fire, but not your possessions. Renter’s insurance also includes liability for people injured in your home, like homeowners insurance.
• Umbrella insurance covers you against other liabilities. If you are sued, or if your liability exceeds what your primary insurance will cover, an umbrella policy will protect you. Most umbrella coverage pays for auto accidents. An auto policy might cover $300,000 in liability, but if the driver gets sued for $1,000,000, then umbrella insurance would pay the extra $700,000.

Health insurance:

Health insurance pays for medical expenses. It has many additional options, including:

• Supplemental insurance covers extra expenses your health care plan doesn’t cover. If you’re injured, your health care might pay your hospital bills, but if you lose income during your recovery, you’re on your own. Supplemental insurance can offer cash payouts to replace lost income or pay deductibles, co-pays, etc.
• Critical Illness insurance covers specific diseases and traumas. A company might sell policies for the risk of cancer, stroke, or specific diseases like Alzheimer’s or Parkinson’s. This can help pay the extra costs of coping with these kinds of situations.
• Disability insurance protects your income stream if something makes it impossible for you to work. Short-term disability might cover people during a protracted recovery (up to a year in some cases), while Long-term disability replaces a portion of your income when the short-term benefit ends.
• Long-Term Care insurance covers the cost of care in an assisted-living situation. These might include home care, adult daycare, hospice care, or entering a nursing home or assisted living facility.
• Dental insurance is often separate from health care plans. Most people need a set amount of dental care (regular checkups, etc.) and certain dental issues may be covered by your primary health insurance. Dental coverage can fill in gaps, or cover other kinds of procedures a dentist might offer.

Basics of life insurance:

Life insurance covers you against loss related to death. If you are the one who dies, the insurance company pays a specified sum to your beneficiary. The primary purpose of life insurance is to replace income lost because of the death of the wage earner, but may also be meant to cover costs associated with final expenses (funeral, burial, etc.).

• Term life insurance covers you in the event of a death during the covered term of the policy. You might have a term life policy that covers you for 25 years, or until you reach age 65. Most life insurance is term life.
• Whole life insurance pays if you die, no matter how long you live. Also called “permanent” life insurance, it includes whole-life, universal life, and variable universal life insurance.
  • Whole life includes a savings account that grows over time and pays you a specific benefit when you die.
  • Universal life lets you increase your death benefit, and includes a savings account that earns higher interest rates. This account can be used to pay some of your insurance premiums if there are enough funds.
  • Variable life insurance lets you invest the savings account funds in stocks, bonds, or mutual funds. The investment's performance will affect the death benefit.
  • Variable Universal life insurance combines features of variable and universal life policies.
• Life Insurance For Children & Retirees—since the primary goal of life insurance is to replace the income of the deceased, it may not make sense to get life insurance for children or the senior. A small policy that pays for burial and funeral expenses would cover any direct costs, but anyone who is on a fixed income or not yet in the workforce wouldn’t need insurance to replace earnings they don’t have.
• Paying out Life insurance: usually the insurance company will pay the policy within 30 to 60 days of the claim. If the insured person dies too soon after taking on the policy, there may be extra delays. The insurance company will investigate to be sure there was no fraud. If the insured was killed, the insurance company will work with the police to ensure the beneficiary isn’t guilty of the murder before paying a benefit. Likewise, there are typically clauses preventing payout if the insured commits suicide within two years of purchasing life insurance.

Other factors that can void a life insurance policy include crime (your insurance company won’t pay if you are shot while robbing a bank), or if you participated in a dangerous activity and didn’t disclose that on the form. You can also be denied if you lie about your health or smoking status when purchasing life insurance.

• The payout may be a lump sum, where the full benefit is paid at once, or it may be paid in annual installments or annuities. Since the insured is trying to replace lost income, it often makes sense to structure the payouts over time, to make sure the funds last and are there to provide for the deceased’s dependents.
• Some insurance policies allow pre-death benefits, where if a person contracts a terminal illness, they can collect some of their insurance money before they die. They are essentially borrowing against the value of their life insurance, and the debt is repaid from the policy when they die, with anything remaining going to their beneficiaries.
• Life insurance benefits are not subject to estate taxes. Very rich people can leave $5.49 million dollars to their heirs tax-free, but after that the government takes 40 percent in estate taxes. Those wealthy people often spend that money instead on expensive life insurance policies, which allow their heirs to collect an insurance payout with no inheritance taxes.

Other kinds of Insurance

• Travel insurance will cover you if you get sick or injured during a trip. It helps if you are abroad and won’t be near your regular healthcare network, since your health insurance might only cover you at specifically approved hospitals.
• Pet insurance covers veterinary bills resulting from accidents or illnesses.
• Credit insurance is often sold by your credit card company. If you are unable to make your monthly credit card payments for some reason, the insurance policy pays the minimum monthly payment for you. (We rarely recommend this kind of insurance—better to pay off your credit card balances and avoid this extra expense). PMI, or private mortgage insurance, is a kind of credit insurance required on home loans where the borrower has less than 20% equity.
• ID Theft insurance promises to pay for the costs associated with recovering from identity theft. This is hard to recommend, given that ID Theft takes your time and energy, but not necessarily your money. It’s stressful to correct ID theft’s impact on your credit, but it’s hard to put a real dollar amount on that stress for the purposes of insuring against it.
• Rental Car insurance is offered when you rent a car, but most people don’t need it. Either your normal auto insurance policy covers you while driving a rental car, or the credit card you use to rent the car includes rental car insurance or both. It’s very rare that you need rental car insurance when renting the car, but if you’re renting a car in another country, or your personal auto insurance policy isn’t comprehensive, rental car insurance might be a good idea.
• Workers’ Compensation insurance is designed to pay medical benefits and replace lost income if a worker is injured on the job. It is usually required by state law for employers to get this coverage for their employees.

As with all of our Financial Literacy Month topics, the subject of insurance is huge, and we’ve only provided a basic overview. There’s a lot more to learn, and if you’re interested, we recommend starting with the excellent Insurance Information Institute online.

If you want to learn more about budgeting or personal finance, get started with free, confidential counseling and education right here at credit.org.

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