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How Insurance Works

How insurance works

How do I know if I need insurance?

Broadly speaking, insurance provides you with financial help when something bad happens unexpectedly or accidentally, for example, if your apartment catches fire or you are in a car accident. If you have the foresight to sign up and pay for insurance coverage before that event, your insurance may help you pay for (or “cover”) the things you lost or that need repair. Deciding whether or not you need insurance is about deciding whether the peace of mind you get for paying for insurance is worth the monthly cost. When it comes to health insurance, for example, the average cost of treatment for a heart attack is $39,000 and that for cancer can be in the hundreds of thousands. Knowing financial assistance from your health insurer will keep you and your family from bankruptcy—or, worse, having to forgo medical treatment—can feel like a small price to pay.

Check out our Insurance Terms Glossary to learn common words used in insurance policies.

Can I get insurance coverage to help me pay for something that has already happened?

Unfortunately, insurance doesn’t work that way. You may receive a payout from an insurance company only if you signed up and paid premiums before you find out you need the coverage. Likewise, if you deliberately do something in order to make a claim (for example, crash your car or quit your job), you will not be eligible for protection. Insurance pays for only unexpected and/or accidental losses. Once that loss has happened (or you know it is about to happen) it is too late for you to insure yourself against it.

How are insurance companies able to pay out large amounts of money to me when I only pay them a little bit each month?

Insurance companies are able to provide people with financial help because they pool the money from all of their policyholders, knowing that not all policyholders will find themselves in circumstances where they need a payout. That’s why they can pay you more money than you paid them should you need it.

How do companies decide what circumstances, such as pre-existing conditions, to exclude from coverage?

There are lots of reasons for exclusions. Sometimes insurers cannot cover catastrophic, widespread losses (such as those caused by war) because, should they occur, they are likely to affect the majority of their policyholders—making it unfeasible for the insurer to cover everyone’s losses. Other circumstances may be excluded because the policyholder could or should have predicted and/or prevented the loss (for example, you can prevent theft by locking your car doors). These are just a few reasons why some losses are excluded.

How are premiums determined?

Sometimes an insurer will determine the cost of your insurance (your premium) by looking at your individual “risk profile.” If you are more likely to find yourself in need of insurance coverage (for example, if you have a history of high-risk driving) or in need of especially costly protection (for example, if you drive an expensive car), your premiums may be higher.

Other times, insurers will provide individuals with different combinations of premium and coverage amounts to choose from. In that case, they leave it up to the individual to analyze their own risk of such a loss occurring and let them decide how much they are willing to pay and the amount of coverage they may need.

Why do premiums sometimes increase?

Insurance companies continually analyze the risk profile of their policyholders, the cost and frequency of claims and the amount of money policyholders pay to them each year. Insurers may adjust premiums in order to hedge against the risk of financial loss.

Why do insurance policies have waiting periods?

A “waiting period” is the amount of time a policyholder, after paying the first premium, must wait before some or all of their insurance coverage comes into effect. This is a standard inclusion in most insurance policies. Only after the waiting period has passed are you eligible for benefits and can submit a claim to the insurer. Waiting periods allow the insurer to protect unknown events for as many people as possible at affordable prices. Without a waiting period, people with known losses may buy coverage and drive up the cost for all. Waiting periods vary, so make sure you understand your insurance policy coverage before signing up.

How do I decide how much coverage I need?

It seems logical you would want to pay the lowest premium possible. But that’s not always the case. People who are “high risk” of finding themselves in need of coverage may be better off paying a higher premium if that means they will get a larger payout or have less out-of-pocket costs. People with many health problems, for example, may decide to pay a higher premium each month rather than have a policy with a low premium and a high deductible because they think it is likely they will need access to less expensive medical care throughout the year. Part of deciding what kind of coverage you need, therefore, is deciding how likely you are to need it and how much insurance you can afford.

Couldn’t I just save my money instead of buying insurance?

Yes, but let’s take a look at the numbers. Let’s say you put $10 each month into your savings account. After 1 year, you’d have $120. If you suddenly needed money to pay for an unexpected loss, that is all the money you would have. On the other hand, if you put that same $10 toward insurance coverage, you would get a much larger payout for a covered loss. With insurance you put a little in and—should the worst-case scenario come to fruition—you get a lot more out.

Do I get my money back if I never make a claim?

You do not get your money back if you do not experience a loss that is covered by your policy. For some people, however, the cost of insurance is not only worth it if they experience a loss that is protected, it is also the price of the peace of mind that comes with knowing you are protected when you are most vulnerable.