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How Does Insurance Work: A Complete Guide

Published May 14, 2021

7 minute read

Devon Taylor

By Devon Taylor

You’d have to be literally living under a rock to have never heard of insurance. It’s everywhere — home insurance, car insurance, life insurance, health insurance. You can’t really exist in modern society without at least being aware of insurance. However, if you’ve never had to research or buy your own insurance policy before, you might feel a bit overwhelmed by the entire concept. If you’ve ever found yourself pondering “how does insurance work?”, don’t feel embarrassed. The insurance industry can be a complex and hard-to-navigate thing. That’s especially true for younger, inexperienced people (or anyone else who has managed to avoid it in their lives so far). This article will serve as your basic insurance primer, giving you all the details you need to get started.

What Is Insurance?

Simply put, insurance is a transfer of risk. When you take out an insurance policy, you are paying a fee to transfer the risk that something bad might happen. It could be an accident that damages your home or vehicle. Or it could be even more serious, like an extreme health problem or even death. Insurance policies are used to hedge against the risk of financial losses, both big and small, that may result from these types of situations. They can also protect against liability that you might accidently cause to a third party.

Insurance is basically a contract, represented by something called an “insurance policy.” In exchange for financial payments, you receive protection from potential losses. The insurance company itself pools all of the monthly premiums into a fund, which is then used to provide payments to customers who file a claim. The pooling of these monies is what helps make insurance affordable for everyone.

The Basics

There are many different types of insurance policies available. The most common types are home, auto, and life insurance. These types of insurance are often referred to as “the big three” by insurance companies. In the U.S., most people also need health insurance. You either get it through your employer or take out private third-party health insurance. There are many other types of insurance policies too, like renter’s or disability insurance.

Some insurance policies can be more obscure. You can even get drone insurance, pet insurance, or insurance for potential legal fees. There are also insurance policies available for very specific needs. Sometimes the rich and famous take our kidnap and random insurance. Medical professionals typically have some form of malpractice insurance. Private businesses often buy a professional liability insurance (also known as errors and omissions insurance).

Most individuals (or businesses) can find an insurance company willing to insure them for just about anything, for a price. Some types of insurance are actually required by law, such as car insurance. Additionally, there are specific types of insurance just for businesses, depending on the types of risks that a particular business might face. For example, a restaurant may need a policy that covers damage or injury that occurs as a result of cooking with a deep fryer.

In summary, insurance is when an individual or business pays a regular amount of money (the premium) to a company, in exchange for guaranteed protections from certain incidents or losses. The insurance company promises to pay a pre-agreed amount in compensation to the policyholder if they are forced to make a qualifying claim.

Insurance Policy Components

Most insurance policies contain three main components: the deductible, premium, and policy limit. Understanding these components is important. They will help you choose the right policy to suit your needs.


The insurance premium is essentially the price. It’s typically expressed as a monthly fee. In some cases, you could pay it quarterly or annually instead. The premium is determined by the insurance company, based on their assessment of the risk involved. Your insurance premiums can also be affected by your creditworthiness. The easiest example of this is a bad driver, with a history of speeding tickets or at-fault accidents. They will have to pay more of a monthly premium for car insurance compared to someone with a spotless driving record. It still pays to shop around though, since different insurers may charge lower premiums for similar policies.

Policy Limit

The policy limit refers to the maximum amount an insurer will pay to cover a loss. Maximums may be set in multiple ways. They may be set per period (for example, $1,000 of dental coverage per year in a health insurance plan. They could be set per loss or injury (like a $1 million life insurance policy). Some policies have a lifetime limit too, known as the “lifetime maximum.”

Typically, the higher the policy limit is, the more the premiums costs. For a general life insurance policy, the maximum amount the insurer will pay is sometimes also referred to as the “face value.” It’s simply the lump sum amount paid to a beneficiary when the insured person passes away.


A deductible is a specific amount of money that a policyholder must pay out of their own pocket before the insurer pays a claim. Deductibles serve as deterrents to large volumes of small and insignificant claims. They can apply per-policy or per-claim, depending on the insurance company and the type of policy involved.

Let’s assume your auto insurance includes a $1,000 deductible, for example. You get rear-ended at a stop light, and the damage to repair your vehicle is $5,000. Your policy requires you to pay the first $1,000, with the insurance company covering the other $4,000. Your deductible is often negotiable, but only before you sign the policy agreement. Getting a lower deductible (or none at all) will drive up your premiums. Conversely, you can save on your monthly premiums by agreeing to a larger deductible.

Types of Insurance

There are many types of insurance. We cover even the most obscure ones over in our insurance section. However, here is a brief rundown of what most people consider to be the Big Four types of insurance. It would take a considerable effort to go through your entire life without having to deal with at least one of these insurance types. In fact, most of us will probably worry about all four.

Life Insurance

Life insurance is a pretty basic type of insurance. The insurance company agrees to pay out a specific amount in the event of the death of the insured. The money goes to a pre-designated beneficiary (usually your children, or other stated heirs). The amount is sometimes referred to as a “death benefit.”

Depending on the policy details, there may be smaller payouts for terminal or critical illnesses. You can also get Term Life Insurance (which expires after a set number of years) or Whole Life Insurance (which never expires, as long as the premiums are paid). Other expenses, such as funeral expenses, can also be included as part of life insurance benefits.

Home Insurance

Home insurance is a form of property insurance. It covers most losses or damages that could occur to your house, including your belongings and assets kept inside. Most home insurance also provides liability coverage against any accidents that might occur on your property. Home insurance usually isn’t a legal requirement. However, most mortgage lenders consider it a mandatory part of any lending agreement. Even if your mortgage provider doesn’t demand it, why wouldn’t you insure your house? It’s probably the most expensive thing you’ll buy in your lifetime. Plus it’s your home.

Automotive Insurance

Auto (or car) insurance covers driver and vehicle owners in the event that they are involved in an accident. It also covers the vehicle being stolen, vandalized, or damaged by a natural disaster. Instead of paying all of the out-of-pocket for costs associated with a car accident, you just pay insurance premiums to protect yourself.

If something happens to you vehicle, the insurance company will step in to cover most (or all) of the costs. They can pay to fix your car, cover your legal fees if you are sued in a civil court over an accident, and cover the medical bills of the occupants of the other car(s) involved in an accident. In most jurisdictions, car insurance is a legal requirement to take your car on the road.

Health Insurance

Health insurance is coverage that typically pays for medical care, surgical needs, prescription drug, and sometimes even dental or vision expenses. Even countries with universal healthcare often have additional types of health insurance. For example, people living in Ontario, Canada don’t typically have coverage for dental, prescriptions, or eyeglasses (even though a trip to the local ER is free).

For Americans, health insurance of some kind if very important. You may receive it through your employer (who may also pay for some or all of the premiums). If not, though, you can also buy your own third-party health insurance to cover you and your family. The cost of health insurance can vary greatly, depending on the coverage you’re seeking and the medical history of those insured. You can expect the health insurance situation in the U.S. to continue changing, as the push for universal healthcare continues to gain steam.

Other Types of Insurance

As mentioned, there’s no shortage of insurance that people can takeout. It all depends on your needs, and what you’re willing to pay in premiums. Individuals and businesses can take out insurance to cover almost anything — from vet bills for your pet to your hobby drone accidently crashing through the neighbor’s window. There are plenty of headline grabbing insurance policies too. You may have read about famous singers insuring their voices, super models insuring their legs, or the Wimbledon tennis tournament insuring against having to cancel the event due to a pandemic. That last one really paid off handsomely, unfortunately. If there’s an insurance need, chances are there’s an insurance company willing to write a policy to cover it.

The Bottom Line

Insurance is an important component of most people’s daily lives. Having home, auto, health, and life insurance provides peace of mind that you’re covered in the event that something unexpected or unfortunate happens. What type of insurance you needs (and how much) depends on their unique circumstances.

Taking a careful inventory of your personal life will help you determine exactly what your insurance needs are. They will probably change frequently over your lifetime. You don’t need house insurance if you’re still young and renting an apartment, for example. Health insurance may not be a major concern until you start to get older and have children of your own. If you’re not sure what coverage you need, we recommend contacting a licensed insurance broker. They will walk you through all of your options and help you get affordable and reliable protection.

how does insurance work


Devon Taylor

Managing Editor

Devon is an experienced writer and a father of three young children. He's simultaneously trying to build college funds and plan for an eventual retirement. He's been in online publishing since 2013 and has a degree from the University of Guelph. In his free time, he loves fanatically following the Blue Jays and Toronto FC, camping with his family, and playing video games.

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