What is Insurance?

Insurance is a contract, also referred to as a policy, where an individual is protected from financial losses by an insurance company. In order to receive protection, the company will require you to pay a fee called a premium. In return, you will be provided with a sum of money if you come across an incident where you suffer financial losses, and the premium you pay covers the incident.

The purpose is to provide you with financial protection, secure your assets, and maintain your financial well-being. You can partially or entirely avoid financial liability for damage or injuries as a result of an accident. You can also protect against losses resulting from fires, theft, vandalism, car accidents, or serious health issues.

Common Terms

  • Policy: A legal agreement between the insured and insurer. It is also referred to as a contract that specifies which events or scenarios that you will be covered for and how much compensation or benefits the insurer will pay the insured individual.
  • Policy limit: The maximum amount of compensation that an insurer will pay the insured individual, only if the event that instigated financial losses is covered and specified in the policy.
  • Policyholder: The individual who holds the policy with an insurer. In most cases, the policyholder is usually the insured.
  • Insured: The individual who is offered protection by a policy.
  • Insurer: The insurance company that offers a policy to protect insured individuals.
  • Deductible: A specific amount of money the policyholder needs to pay for a financial loss before the insurer covers the rest.
  • Premium: The amount that individuals must pay in order to receive coverage to protect financial losses. A premium is also referred to as the price of the policy.
  • Grace period: After an individual purchases insurance, a specific amount of time is given to the individual in which he/she is allowed to cancel the policy for a full refund of premiums. The grace period varies by different insurers because some companies could offer a few days, while other companies could offer a few weeks.

How Does Insurance Work?

The insurer determines the amount of premium that the insured person must pay based on the risk that the insured events will occur. Different people will be subject to varying amounts of risks for different events. For example, a new driver who is recently issued a driver’s license will need to pay more premium for car insurance in comparison to an experienced driver.

The premiums that insured individuals pay are grouped together with the premiums that others pay for an insurance company.

The pooled money is then used as compensation for insured individuals if they need coverage for financial losses.

If accidents or damages occur and such events are covered in an individual’s policy, then the policyholder will need to file a claim with their insurance company in order to get their financial losses protected. It involves telling the company what happened so that they can verify whether or not the event is covered under the policy that they agreed with.

Other Important Considerations

Every person will require different types of protection and coverage based on where they live, how old they are, how they are employed, and other various lifestyle choices. For example, an individual who travels often will consider purchasing travel insurance, an elderly person may consider long-term care insurance, or an individual who bought a new home may consider homeowners insurance.

Therefore, not everyone will receive the same coverage and be financially protected in the same way. Everyone will differ from each other as individuals choose the type of policy that is the most applicable in their lives. Depending on where they live, some policies may also be required by law.

Additional Resources

CFI is the official provider of the Financial Modeling & Valuation Analyst (FMVA)® certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Life and Health Insurers
  • Modified Endowment Contract (MEC)
  • Property and Casualty Insurers
  • Vanishing Premium Policy
  • See all wealth management resources

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