Insurance: Definition, How It Works, and Main Types of Policies

What is insurance? 

Insurance is a way to manage your risk. When you buy insurance, you purchase protection against unexpected financial losses. The insurance company pays you or someone you choose if something bad happens to you. If you have no insurance and an accident happens, you may be responsible for all related costs. Having the right insurance for the risks you may face can make a big difference in your life. People get insurance not only to help with risks from unexpected events but also to help pay for routine things, such as annual medical checkups and dental visits. In addition, insurance companies negotiate discounts with health care providers, so their customers pay those discounted rates. An insurance policy is a written contract between the policyholder (the person or company that gets the policy) and the insurer (the insurance company). 

The policyholder is not necessarily the insured. An individual or company may get an insurance policy (making them the policyholder) that protects another person or entity (who is the insured). For example, when a company buys life insurance for an employee, the employee is the insured, and the company is the policyholder. How does insurance reduce your financial risk? Imagine you’re driving your car and you hit a deer, which damages your car. 

If you have the right kind of auto insurance policy, the insurance company will pay the costs of the car repairs (minus the deductible — the portion you have to pay). Now, imagine a water pipe bursts in your bathroom, ruining everything in that room and in the bedroom next to it. Typically, if you have homeowner’s or renter’s insurance, the insurance company will pay to replace some or all of the damaged property, once you pay your deductible. Insurance policies will only pay for things that are described in the policy. So it’s important to read a policy carefully before you buy it so you’ll know exactly what’s covered.