How Does Insurance Work?

Insurance is a product sold by companies to safeguard you and/or your property against the risk of loss, damage or theft (such as flooding, burglary or an accident).

Some types of insurance you must purchase by law, such as auto insurance if you drive a vehicle; some you may need as a condition of a contract, such as building insurance as a requirement of your mortgage; and others are sensible to purchase, such as life insurance.

While it is a good idea to make sure you are not paying for insurance that you don’t need, you should always think about what would happen if disaster struck and you didn’t have coverage to protect you, your family or your business.

You can buy insurance policies for many aspects of your life, for example for your health, home, car or business. An insurance policy is the contract that you take out with an insurer to protect you against specific risks under agreed terms.

How it works

When you buy a policy, you make regular payments, known as premiums, to the insurer. If you make a claim, your insurer will pay out for the loss if it is covered under the policy. If you don’t make a claim, you don’t get your money back; instead it is pooled with the premiums of other policyholders who have taken out insurance with the same insurance company. If you make a claim the money comes from the pool of policyholders’ premiums.

How premiums are calculated

Insurers use risk data to calculate the likelihood of the event you are insuring against happening. This information is used to work out the cost of your premium. The more likely the event you are insuring against is to occur, the higher the risk to the insurer and, as a result, the higher the cost of your premium.

An insurer will take two important factors into account when working out the premium they will charge.

• How likely is it in general terms that someone will need to make a claim?
• Is the individual who wants to purchase a policy statistically a greater or smaller risk than the ‘average’ policyholder.  For example, a young person with a high-performance car may be charged a higher premium as they are statistically more likely to be involved in an accident than a mature, experienced driver.