Protection: The Basics of Insurance
The insurance sector is one of the most important financial areas in American life. It touches the individual lives of nearly every American and dramatically impacts the overall economy. Although insurance is a critical part of any healthy financial plan, many people find the myriad types of insurance contracts and companies confusing. This is unfortunate and entirely unnecessary. Even a broad understanding of a handful of definitions and practices of the insurance sector allows people to protect themselves and their loved ones from serious financial difficulties.
What is It?
Insurance is a risk management contract between the insurer and the insured. The insurer is the company that promises to make a specified payment to the insured if a specific event occurs. The insured is the company’s customer who pays premiums to guarantee the prescribed payment if the prescribed event occurs. A premium is an agreed-upon price of incremental or upfront fees the insured pays the insurer. Deductibles are another vital part of insurance policies. A deductible is a dollar amount the insured pays out-of-pocket before the insurer pays a claim. For example, Clay (the insured) pays a $200 a month premium with a $500 deductible to Geico (the insurer) for automobile insurance. Clay’s car was damaged in a hit-and-run, and the total repair cost is $1500. According to the policy, Clay will pay $500 of the repair costs, and Geico will pay the remaining $1000.
The insurance sector is composed of companies primarily organized as capital stock or mutual firms. Capital stock insurance companies are owned by shareholders and obtain the majority of their capital from the company's publicly sold shares. Stock companies use their profits in a few ways. They can pay off debts, provide dividends to shareholders, or reinvest within their company. The goal of stock companies is to make their shareholders more money. Allstate and Metlife are examples of capital stock companies. Mutual insurance companies are owned by its policyholders. The goal of mutual insurers is to maintain enough capital to meet the needs of policyholders. Any surplus a mutual company earns is given to policyholders as dividends or retained by the company to lower the policyholders’ premiums. If a mutual insurer needs capital, it must borrow funds or increase rates. Well known mutual insurers are Northwestern Mutual and Mutual of Omaha. Stock companies generally seek short-term, high-risk assets to make profits, while mutual companies seek long-term low-risk assets to keep the company solvent for its policyholders.
Both capital stock and mutual insurers offer many types of insurance contracts. The four most popular forms of insurance are life, medical, property, and causality. Insurers offering life insurance guarantees a death benefit to the insured's beneficiaries upon the insured's death. A death benefit is the agreed-upon amount of money the insurer gives to the insured’s beneficiaries. Medical insurance covers medical and surgical costs incurred by the insured. Medical insurance has a variety of different plans with distinct payment and benefit systems. Property insurance is a broad category of coverage that provides property protection. Property insurance policies can cover weather damage, vandalism, or theft of nearly any tangible property. Property insurance can also cover liability damages if a policyholder is responsible for another person’s injury on or while using their property. Casualty insurance is similar to property insurance but focuses more on liability protection. Casualty policies often protect the policyholder from financial loss if he/she is liable for injury to another person or damage to another person’s property. Vehicle and workers compensation coverage are examples of casualty insurance.
The insurance sector possesses investment advantages over traditional investment firms. Insurance companies can invest their clients’ money like banks. However, because the insured does not expect payments from the insurer until after a conditional event occurs, insurers have more freedom to invest funds than banks, as banks must always account for their clients withdrawing funds at any possible moment in their investment plans. This is referred to as insurance float. Insurance float guarantees insurers enjoy a positive cost of capital, which means they have more equity than debts. This allows consistent low-risk and stable returns on investments.
Insurance may seem complicated and frightening, but it can be a bastion of financial security in a chaotic world when used effectively. It supports whole industries and can buttress investment portfolios from unnecessary risks. An intelligent approach to the insurance sector can be a great benefit to people of all walks of life.