How does insurance work?

Insurance lets many people each pay a small, known amount so the few who have a costly loss can be paid back. Use it for losses you could never cover yourself, and use your emergency fund for the small ones.

Insurance pools risk

Many people pay premiums into one pool. In any year only a few have a big loss, and the pool pays them. Everyone trades a small certain cost for protection from a large uncertain one.

Four words to know

The premium is what you pay to keep the policy. The deductible is what you pay first on a claim. The coverage limit is the most the insurer will pay. A claim is your request for payment.

Insure big, self-insure small

Buy insurance for losses that would wreck your finances. Cover small, likely costs from your emergency fund, which is cheaper over time than paying extra premium for low deductibles.

Some insurance is required

Most states require auto liability insurance to drive, and many landlords and lenders require renters or homeowners coverage. Health insurance is often offered through your job.

How pooling risk works

Imagine 1,000 renters. Each has a small chance of a fire or theft in a given year, and if it happens, replacing everything costs about $20,000. No one knows who it will be.

Say about 10 of the 1,000 have that loss each year. That is 10 × $20,000 = $200,000 in losses. Split across 1,000 people, it comes to $200 each. If everyone pays a bit more than $200 to cover the company's costs, the unlucky 10 are made whole. These are example figures, but real pricing works on the same idea, using data on how often losses happen.

Premium, deductible, limit and claim

The premium is the price of the policy, paid monthly, every 6 months or once a year. If you stop paying, the coverage ends.

When something goes wrong, you file a claim: you tell the insurer what happened and send proof, like photos, a police report or a repair estimate. The insurer checks that the loss is covered.

You pay the deductible first. The insurer pays the rest of the covered cost, up to the coverage limit. If a loss is bigger than the limit, you owe the difference. Health plans add a few more terms, covered in the health insurance lesson.

Why you insure big losses and not small ones

An insurer has to pay its staff and make a profit, so on average people pay in more than they get back. That trade is worth it for a loss you could not survive, like a $50,000 hospital bill or a lawsuit after a car crash.

It is a poor trade for small, common costs. Paying a higher premium to lower your deductible from $1,000 to $250 often costs more over a few years than the $750 it saves. Your emergency fund is your own insurance for small losses. It is why building one first lets you choose higher deductibles and pay less.

The main types a young adult meets

Health insurance pays for doctor visits, prescriptions and hospital care. Medical bills are a common cause of debt, so this is usually the first policy to get.

Auto insurance covers damage you cause to other people (liability), and can cover your own car (collision and comprehensive). Renters insurance covers your belongings and your liability if someone is hurt in your home. Most landlords' policies don't cover your things.

Disability insurance replaces part of your pay if illness or injury stops you from working, and many employers offer it. Life insurance pays your family if you die. You need it once someone depends on your income, such as a child or a partner who shares a mortgage.

What to check before you buy

Look at five things. The premium and how often it is due. The deductible, and whether you could pay it today. The coverage limits. The exclusions, meaning what the policy won't pay for. And how claims are filed.

Check that the company is licensed in your state. Your state insurance department lists licensed insurers and takes complaints. Be wary of anyone who pushes you to sign that day.