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How Insurance Works: The Basics

Insurance is a must-have product that can protect your home, your family and yourself.

Written by Jess Ullrich / June 10, 2022

Quick Bites

  • Insurance can be an affordable way to protect yourself financially.
  • There are myriad kinds of coverage and policies available to suit your particular needs.

If heavy rain is in the forecast, you’ll probably pack an umbrella on your way to work or to the grocery store. The umbrella offers protection from getting soaked in a downpour.

Insurance works similarly to the umbrella, except instead of keeping you dry, it protects your money in the event of an accident or life-altering event.

Here’s what you need to know about how insurance works.

Inside this article

  1. How insurance works
  2. Why do banks require insurance?
  3. What do most people get?
  4. How to get a good price
  5. What makes rates go down?
  6. What do you need?

How insurance works

Insurance at its essence is a contract between you and an insurance company in which you pay a regular amount of money in exchange for a guarantee that they will provide financial protection.

In cases of health and car insurance, you may be subject to a deductible, or an upfront cost that you pay out of pocket before your insurance kicks in. The cost of the deductible will vary based on the policy and other factors. Life insurance doesn’t have deductibles. If you die during the term of the policy, your family gets the agreed-upon cash and that’s the end of the story.

In some cases, insurance will fully cover your costs. In others, you may have to pay a percentage out of pocket.

Why do banks require insurance?

You don’t always need insurance but in some cases, you may have no choice.

If you’re financing a home or vehicle, your bank may require it. Both mortgage and auto loans are secured with collateral, ie, your car or home. The collateral helps protect insurance companies from risk. If you stop paying your premiums, the insurer can seize that collateral–ie, your home or car, which makes it a pretty good idea to not stop paying your bills.

What are the types of insurance most people get?

In addition to common policies like homeowners or renters, auto and health insurance, many people also choose to purchase long-term disability coverage and life insurance. Each type of coverage protects you in a different way.

For instance, life insurance can help cover the cost of your burial and funeral and protect your family financially when you die. Long-term disability coverage can pay for your expenses if you’re injured and out of work for a long time.

How do you get a good price on insurance?

The price you’ll pay for insurance coverage will vary based on the policy you choose and a number of other factors from age to your hobbies.

For life insurance, for example, whether or not you smoke will be fundamental. For auto insurance, your age and gender will also make a difference.

While some factors are outside of your control, consider working to improve things like your credit score before you apply for coverage. It’s also a good idea to shop around and compare quotes from different insurers, as costs vary based on the provider you choose.

What makes insurance rates go down?

Generally speaking, your insurance rates will be lower if you have a high credit score or live in a low-crime area. But the factors impacting your rate will vary depending on the policy you’re shopping for.

For instance, you may get lower premiums with health insurance if you’re in good health overall and don’t have any major risk factors. With homeowners insurance, what matters may be whether or not your home has recently-upgraded electrical and security systems.[2]

The amount of coverage you get and the deductible you’ll pay will also impact your monthly premiums. Typically, your monthly insurance costs will be lower if you opt for less coverage and pay a higher deductible. But this isn’t always the best strategy because you could end up paying more out of pocket if something happens.

How do you decide what coverage you need?

You’ll most likely need health, auto and homeowners insurance, as most states and lenders require minimum levels of coverage. If you’re risk-averse and interested in additional financial protection, you may also want to get long-term disability and life insurance coverage.

To decide which coverages are right for you, consider your family and financial situation. Then, consider different scenarios and ask yourself some essential questions.

Would you be able to afford x cost if x happened? How would it impact your finances over the long term?

The type of coverage you need will depend on your unique situation and preferences.

Article Sources
  1. “Fatality Facts 2020: Males and Females.” Insurance Institute for Highway Safety. https://www.iihs.org/topics/fatality-statistics/detail/males-and-females
  2. “12 Ways to Lower the Cost of Your Homeowners Insurance.” Insurance Information Institute. https://www.iii.org/article/12-ways-to-lower-your-homeowners-insurance-costs

About the Author

Jess Ullrich

Jess Ullrich

Jess Ullrich is a personal finance writer who's been creating online content since 2009.

Full bio

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