Common Insurance Types & Terms
What is Insurance?
Insurance is a means of providing protection against financial loss in a number of situations. It is a contract in which one party agrees to pay for another party's financial loss resulting from a specified event. Insurance works on the principal of sharing losses. If you wish to be insured against any type of loss, you purchase a policy from an insurance company and make regular payments, called premiums. In return, the company promises to pay a specific dollar amount for the type of loss determined in the policy.
Insurance has deep roots, tracing all the way back to The Code of Hammurabi, a collection of Babylonian laws of 1700 BC, which were believed to have provided the first kind of credit insurance. Under the code, a borrower did not have to repay a loan if personal misfortune made it impossible to do so. Modern insurance can be traced to the Great Fire of London in 1666, which consumed 13,200 houses and brought property owners in the city to near financial ruin. In the aftermath of this disaster, Nicholas Barbon opened an office to insure buildings, and the modern insurance industry was born.
Types of Insurance
All insurance policies require the owner of the policy to make regular payments ("premiums") and pay the owner a sum of money ("the benefit") when an insured event occurs. There are three major types of insurance policies sold:
1. Life Insurance: A life insurance policy provides that the insurance company will pay a certain amount when the insured person dies. The benefit may be paid in a lump sum or in installments to the beneficiary. There are various forms of life insurance, most of which can be categorized into one of two main types:
- Term Life Insurance - A term life insurance policy typically has constant payments over a fixed period of time (the "term"). If at any time during the term the insured person dies, except in some exceptional circumstances such as suicide, a fixed sum of money is paid out. If the insured person survives through the whole term there is no benefit and the policy has no cash value.
- Permanent Life Insurance - Unlike a term life policy, a permanent life policy (forms of policy that fall under this category include universal life, whole life, and endowment policies) do have a cash value and remain in force so long as the insured person is alive and the premium continues to be paid. Some policies (such as whole life) provide for a constant premium and a constant payout, while others (such as universal life) may allow for variable premiums and variable payouts.
2. Health Insurance: Health insurance pays all or part of the cost of hospitalization, surgery, laboratory tests, medicines, and other medical care. The rising cost of medical care has increased the need for adequate health insurance. You could suffer a major financial hardship without such coverage, especially in case of a serious illness or accident. Health insurance comes in a wide variety of forms, both private and public (i.e. Medicare). Policies may be taken out by an individual, by their employer, or by a combination of both.
3. Property Insurance: Individuals buy property and liability insurance to protect their assets against financial loss. Property insurance provides direct compensation if a policyholder's possessions are damaged, destroyed, or lost as a result of peril or unforeseen events. Liability insurance protects individuals and businesses against possible financial losses if their actions result in bodily injury to others or in harm to property owned by others. The main types of individual property insurance are:
- Home Insurance: This provides protection against losses from damages to an owner's home and its contents.
- Auto Insurance: This is one of the most widely purchased and most important kinds of insurance. Drivers are legally responsible for any costs arising from accidents they cause and must typically either carry a minimum amount of auto insurance (defined by the state) or post a minimum bond to cover their liability in the event of an accident. Auto insurance may simply cover the damage to other's property (collision coverage) or may cover damage to one's own car and the risk of theft and fire (comprehensive coverage)
Financial Viability of Insurance Companies
The financial stability and strength of the insurance company should be a major consideration when purchasing an insurance contract. An insurance premium paid currently provides coverage for losses that might arise many years in the future. For that reason, the viability of the insurance carrier is very important. In recent years, a number of insurance companies have become insolvent (AIG is the most prominent example), which in many cases may leave their policyholders with no coverage (or coverage only from a government-backed insurance pool with less attractive payouts for losses).
Other Terms You May Hear
Annuities: These are savings plans sold by insurance companies to provide a fixed and regular retirement income. If the annuitant (owner of the annuity) dies before receiving the guaranteed number of payments, the insurance company must continue the payments to the beneficiary.
Dividends: Some insurance policies refund part of the premiums in the form of dividends. Such policies are called participating policies. An insurance company pays dividends if the money it collected in premiums exceeds the amount needed to pay benefits and administrative costs. Dividends may also include a share of the profits the company earned on investments made with premium funds. Dividends are most commonly paid on life insurance.