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Everything You
Need to Know About Insurance
·
Insurance
can minimize your financial liability in the case of a catastrophe and give you
peace of mind.
·
When
shopping for insurance, it is important to assess your individual needs to
determine what insurance(s) you will actually require.
The world is a dangerous and risky place. Various
catastrophes can befall an individual, and we as a species survived thanks to
pooled resources and knowledge – after all, the explosion of technology in the
past century finds its foundations on previous work. A magnificent concept
would be a mechanism to mitigate risk in some kind of pool, spreading the risk
among participants, so no single party is left to carry a burden
single-handedly. That mechanism is insurance.
Note: I use liabilities in two ways in this article. The
first is financial liabilities, which are simply financial obligations. The
other is legal liability, as in at-fault responsibility
The Purpose and
Function of Insurance
Insurance is not meant as an ATM or piggy bank to store
wealth until it is needed. In fact, most people would hope never to need to
claim insurance benefits, because the most common precipitator of benefits
claims is some sort of disaster, whether personal or more far-reaching. There are
many purposes of insurance, but the predominant one is to avoid catastrophic
financial liability in the future – and thereby ensuring peace of mind.
Legal
Requirements and Protection Against Financial Liability
Some types of insurance,
such as auto and workman's compensation (for businesses), are required by the
law. This regulation ensures anyone harmed by another's actions does
not further suffer from the liable party's lack of assets. If someone maims you
in a car accident because they were negligent, the legal requirement of auto
insurance guarantees you do not suffer secondary or tertiary consequences from
lack of assets on the liable party's side. Your medical costs will be covered,
regardless of you or the liable party's financial assets. A similar idea
mandates workman's compensation and other insurances.
Financial liability
minimization is a prime motivator. Malpractice, auto, and professional
insurances are designed to protect individuals or businesses whose actions may
cause harm to someone else. Since harm can lead to judgments exceeding an
individual or business's assets, insurance sets an upper limit on losses in the
case of judgment against the insurance holder.
Protection
Against Financial Ruin
Even if you are not
liable for any wrongdoing, you may fall victim to circumstances and require
protection. Another very common purpose of insurance is to negate the
possibility of financial ruin. Auto insurance fits this category for the party
at-fault. Disaster, health, and business insurances also fall under this
purpose. Meeting litigation judgments or re-establishing yourself after a
disaster are two important reasons to carry insurance.
Insurance intended for
personal possessions, such as fire and renter's insurance, gives peace of mind
to the beneficiaries because they know there is not certain bankruptcy in the
future if the unlikely scenario of a disaster plays out. Not carrying
insurance, especially for critical aspects like health and most people's
largest asset (their home and vehicle), can lead to an insurmountable financial
problem from a single moment of destruction.
Policy Basics:
Common Terminology and Mechanisms
As stated above, the main
reason to carry insurance is to mitigate financial liability. This is done by
spreading the risk among several participants in similar-risk pools, which then
may or may not trigger payouts. Insurance is not meant to provide steady
wealth, and indeed the amount paid into an insurance plan will likely be more
than the payout.
Risk-Spreading
Mechanism
As an example, consider a pool of homeowner insurance participants.
Every month, the insured pay a premium into a pool, which is the source of
the benefit money. If one participant's house burns down, the insurance company
allocates some of the assets in the pool to that participant. Most participants
never receive any money, because they have no legitimate claim (i.e., their
house is never destroyed). Hence all participants paid indirectly for one
participant's house, but they all enjoyed the benefit of coverage in the case
that a disaster befell them. Hence risk is spread among all.
This mechanism can and
does break down. During disasters when many claims are made, an insurance
company's assets could conceivably fall short of the legitimate benefits
expectations. A famous example is AIG during the credit crisis in 2008 – claims
against policies held by the company overwhelmed the company and it collapsed.
To avoid this kind of failure, insurance companies are required to have minimum
statutory reserves.
Calculation
Premium and limits
calculations are made by the underwriter, who accepts financial liability on
your behalf. The underwriter considers many factors relevant to the type of
insurance. Actuaries use statistics and mathematical models to determine your
rates and settlement.
Statistics and
probability are a major part of the calculation. If you feel you are
overpaying, remember that insurance policies are usually based on pools and
assumptions. Other companies may treat your situation as less risky and hence
offer you a lower premium or better terms (limits, deductibles, coverage
periods). Make sure to shop around if you think you can get a lower rate.
Common
Terms
Like all industries,
there is a set of important terms used to describe complex subjects. Here are a
few terms you should be familiar with:
·
Premium – periodic payment by
insured to insurer to cover future claims
·
Deductible –
amount the insured must pay before the insurer pays out
·
Lifetime Limit – upper
limit the insurer is required to pay over the policy lifetime
·
Annual Limit –
similar to lifetime, except per year
·
Liability Limit – upper
limit per claim
·
Annuity – yearly payment
(usually a settlement) which spreads a full benefit out over time
·
Underwriter – company
or person (the insurer) who accepts liability for a risk,
thereby transferring risk from the insured to the insurer
·
Collateral – an
asset that is considered at-risk if someone fails to meet financial obligations
(defaulting on a mortgage puts the house (the collateral) at risk of being
repossessed)
·
Structured Settlement –
often an annuity, but not always; this is a benefits payment scheme over time
·
Rider/Endorsement – a
specific change to a basic policy, intended for somewhat common deviations or
to customize a policy to a particular insured
·
Surcharge –
extra cost added to basic premium, usually due to at-fault claims or legal
action (a traffic violation often results in a surcharge, which can be added in
the middle of a policy period)
·
Actuary – person who
determines rates and settlements for an insurance company based on statistics
and mathematical models
·
Adjustor – person who assesses
the extent of damage in an incident, which is used as the basis for the
settlement offer
Different branches of
insurance also have different terms depending on the branch. "Liability
only" and "bodily injury" make sense for auto insurance, but it
doesn't make as much sense for deposit insurance.
Types of
Insurance
There are plenty of types
of insurance. I have outlined the most common, some less well-known but still
important, and some of the stranger insurance policies available. Remember
insurance is meant to mitigate risk by pooling assets for several participants.
Consumer
·
Health – there are myriad health
insurances
·
Life – paid out to
survivors of the insured
·
Long-Term Care – for
long-term medical care needs
·
Auto– all sorts of vehicles, and
it is usually mandated by law
·
Homeowners -
often does not cover "acts of God" / disasters
·
Disaster – tornado, flood,
earthquake, etc.
·
Kidnap and Ransom – used by
the wealthy but also travelers and workers in dangerous areas of the world
·
Renter – for personal
belongings, not the building
·
Deposit – such as
the FDIC, which automatically protects most depositors at banks
·
Travel – usually
covers medical and other expenses while abroad and the insured's home country
policies do not apply
·
Pet – for your
loveable furry family members
·
Income and Payments –
guarantees payment of common individual liabilities (bills, mortgage) or a
portion of income (useful if savings would be inadequate upon disability or job
loss)
Business
and Professional
·
Malpractice –
doctors and other professionals whose expertise is their job
·
Errors and Omissions – for
advice and service providing professionals (accountants, lawyers, etc.) to
limit negligence claims liabilities; also known as Professional Liability
Insurance
·
Workers Compensation – to
protect businesses when they must pay injured employees
·
Landlord – to cover problems
with a rented building
·
Casualty – for employee deaths
or deaths caused by business operations
·
Ransom and Kidnap – for
employees
·
Data Loss –
more and more relevant insurance meant to protect companies from financial
losses due to loss of data, either malicious or accidental
·
Auto – for fleets
·
Multiple Peril –
bundles several common insurances together to ease the payment process (ex.,
employee health, casualty, and ransom insurance plus auto and building)
·
Crop – used by farmers to
protect against financial ruin if crops are destroyed
Some other types of
"insurance" are not termed insurance but act like insurance. These
are derivative-based financial agreements, such as Credit Default Swaps (CDSs),
which played a major role in AIG's downfall. They are still widely traded, and
for insurance companies, there is an incentive to customize policies for large
corporations. This is the securitization of risk.
Timing – When to
Purchase and When to Reconsider
Insurance is intended to
mitigate financial risks. However, insurance is not always necessary. There are
insurance policies for so many possible problems and many of them simply are
not relevant to all people or entities.
Some of the most important insurances regard life. Health and life
insurance are practical and are much cheaper to purchase when the insured is
far from needing them. Insurance is a business of probabilities, and a young,
healthy, boring individual is much less likely to make a claim on health or
life insurance in the near future. Conversely, a customer who is 95,
smoked and drank all his/her life, and still enjoys skydiving once a week is
much more likely to claim health or life insurance benefits. Timing is
essential when purchasing insurance.
Other insurances, like
auto, are only required when one owns or uses a car. If you plan to live in a
major city with excellent public transit, your auto insurance is irrelevant
(rentals usually have their own insurance attached). Purchase only what you
expect to need, and there is little reason to purchase a plan that extends
beyond that.
Entering into a policy
early will affect lower premiums, but one must be careful not to discount the
time value of money or possible life changes. Furthermore, applying earlier is
better. Waiting can result in delays or denial, especially if a condition
develops too much.
Remember, insurance is
meant to mitigate future financial risks, and thereby it may ensure other
important benefits, such as preventative medical care or income to purchase
food after a major accident at work. Plenty of material is available online,
and it may even prove overwhelming. Hopefully, we
helped simplify some things about insurance for you. If you are
unsure about what insurance is right for you, there are professional insurance
brokers who can offer some assistance in choosing the most appropriate plan for
your needs.
