Basic Elements of Insurance

Insurance is a type of financial product that protects a party such as an individual or business against unforeseeable losses or damages. For instance, a homeowner might choose to purchase homeowners insurance, which would pay the homeowner for the damage done to his home by certain events like fires and storms. There are many different types of insurance policies, but all types of insurance have some basic elements in common.

Policy

A policy or insurance policy is a contract that states all the specific conditions of an insurance plan. It is important to read and understand everything written in a policy before buying the insurance so that you know what benefits you are getting and the limitations of those benefits.

Losses

A loss is the cost of damage inflicted upon a piece of property or person. For instance, if you get in a car crash where the vehicle is totally destroyed, the loss would equal the full value of the car. While "damage" describes harm to a person or object, the term "damages" can describe the amount of money a person is legally obligated to pay another party for damage she caused. For instance, if you were the cause of an auto accident, you may be obligated to pay the other driver damages for losses he suffered.

Perils and Risk

All insurance policies deal with compensating the policyholder against perils. Perils are unpredictable events that can cause damages or losses. Every peril is associated with a certain amount of risk, which is the likelihood that the peril will occur. Geico defines risk as "the chance of suffering a loss." For instance, in auto insurance, a common peril is getting into a collision with another vehicle. When an insurance company creates an auto insurance policy, they assess the risk of the drivers. Drivers with clean driving records will typically be considered less risky and therefore might pay less for insurance.

Premium

The premium is the cost of an insurance policy. Premiums are typically paid on a normal recurring schedule, such as on a monthly, quarterly, biannual or annual basis.

Deductibles

Deductibles are costs that a person must pay toward losses and damages before an insurance company will pay. For instance, if your auto insurance has a $1,000 deductible on collisions and you get in a fender-bender that causes $1,250 worth of damage to your car, you must pay the first $1,000 to fix the car and the insurance company will pay the remaining $250. Deductibles protect insurance companies from having to pay for small losses. Choosing higher deductibles usually reduces premiums for the policyholder.