The dummies guide to insurance

Do you know what insurance is? Or why we need it? Sometimes, going back to basics can clear up any gaps in knowledge or misunderstanding you may not know you have. To help you understand this important financial tool, is the Dummies Guide to Insurance:

What is insurance?

Simply put, insurance is a contract (also known as a policy) between an individual and an insurance company. The policy states specifics about the type and amount of financial protection the insurance company can offer an individual, like you. Insurance is an essential if you have loved ones or assets you need to protect.

A simple guide to understanding insurance

1. Risk, Risk, Risk

In real estate, the mantra is “location, location, location.” In insurance, it’s risk, risk, risk. At it’s essence, insurance is a way of managing risk.

The modern insurance industry got its start in London, England following the plague of 1665 and the Great Fire that ravaged the city the following year. Amidst the chaos and suffering, underwriters who had dealt exclusively in marine insurance started to offer fire insurance as well. It was a way to mitigate the risk of wooden houses. If someone purchased fire insurance and a fire happened, the insurer would pay money to the insured person. So they would be able to rebuild their home.

By the late 1600s, the underwriting companies expanded their range of business into life insurance. This was made possible by the development of actuarial tables — the ability to predict mortality rates and the probability of other events.

Today there are many types of insurance, like car, home, disability and more, but they all evaluate risks in order to determine the likelihood of an accident, illness or life expectancy.

2. All about underwriting

The term underwriting comes from the coffee houses of London, England in the 1600s. Investors willing to cover the risk of shipping literally signed on the contracts “under” the cargo lists. They “underwrote” what they were willing to cover.

The underwriting process is a way of evaluating risk. An insurance company will gather information about an applicant to make sure they meet approval standards. The type of information they need depends on what type of insurance the applicant is seeking.

Using actuarial tables, the insurance company can then determine the risk of covering an applicant. In other words, they can predict the likelihood of a loss, depending on their knowledge of risks for a certain group of individuals.

3. What’s a premium?

The cost of insurance — the premiums we pay — may seem mysterious to some, but they’re based on mathematical formulas. Actuarial tables determine the likelihood of an occurrence and thereby the risk. The cost of insurance — the premiums — are then worked out. Insurance companies pool their clients’ risks to make insurance premiums more affordable.

We hope this guide to insurance has made this important financial product easier to understand. Read more about Term vs Permanent Insurance here in our ongoing Insurance 101 blog series.

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