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Insurance

Insurance: What it is and how it works

Insurance is one of those financial products that you are likely to use and need throughout your lifetime. Be it when you buy a car or become a homeowner, insurance is there to protect you against (nearly) every possible eventuality.

But what is insurance and how does it work? And with all different types of insurance, how do you know what kind you need and whether or not you have got a good deal? We’re here to give you the lowdown on all things insurance to help you make the smart financial choice.

What is insurance?

Insurance is all about risk. Our world is full of risks, and insurance is a way to pay someone else to take on a financial risk for you. With an insurance policy, you buy protection against specific risks that you choose to be protected against. For example, if you own a house you could buy a policy to protect you against risks like a house fire or a burglary. If you drive a car, a policy might protect you if you have a car accident.

Insurance is essentially a contract in which you receive financial protection or reimbursement against losses from an insurance company. It is there to safeguard you or your asset against risks such as loss, damage or theft.

You are required to have certain types of insurance by law. For example, in order to drive a car in the UK you are legally required to have at least third-party insurance. And in some cases, you may need insurance as a condition of a contract, such as building insurance if you have a mortgage. Whether or not to purchase other types of insurance come down to individual choice.

How does insurance work?

How insurance works may seem complicated, but when broken down it’s simpler than it seems. First, you need to select a policy. This will set out everything that you are or aren’t protected against.

With your selected policy you will be required to pay the insurance company a premium. This can either be paid monthly or yearly, or even sometimes just a one-off payment. The price of the premium will depend on the risk and the value of the event or object you are insuring. For example, if you are an inexperienced driver, your premiums are likely to be higher. This is because you present a greater risk, as statistically it’s more likely you will have an accident. As you get more experienced, and avoid accidents and motoring offences, you should find that your premiums will cost less.

Finally, if something were to happen to you, or the asset or event you have insured, you can make a claim. The insurance company will check that what has happened is covered by your policy and then pay out for the loss you have incurred.

Key insurance terms

When it comes to insurance there are some key words and terms that if you understand what they mean, they can make the whole process a lot easier. Let’s break down the ones you really need to know.

Premium

An insurance premium is what you as an individual, or as a business, have to pay to have an insurance policy. It’s the cost of your insurance. You can usually choose how you want to pay your insurance premium. For example you can pay in monthly or semi-annual instalments, or you can pay the full amount upfront before the coverage starts.

The premium will depend on a variety of factors which determine the level of risk you or the item you are insuring represent to the insurer. Insurers will typically consider how likely it is that you will need to make a claim and whether or not you present a smaller or bigger risk than the average policyholder.

Excess

Your insurance excess is the amount you have agreed to pay towards a claim. When you take out your insurance policy, the likelihood is that you will find that you have a compulsory excess. This is what you would be required to pay if you made a claim, before your insurance company covers the rest.

You can sometimes make your premiums cheaper if you choose a higher excess. While this can be a good way to lower the cost of your insurance plan, it is worth remembering if that you do end up making a claim you will have to pay this amount in full.

Policy

An insurance policy is the document detailing the terms and conditions of a contract of insurance. The policy will detail what is protected and what is not protected — basically what claims the insurer is legally required to pay.

When you take out your policy with your insurer, you will most likely receive a policy number. This is a unique identifier which is assigned to your policy, and it is something you will need to provide when having any dealings with your insurer.

Policyholder

When you see the term ‘policyholder’, it is referring to the person or group who holds the insurance policy. So if you were to take out a life insurance policy for yourself, you would be the ‘policyholder’.

Coverage

Insurance coverage is the amount of risk or liability which is covered by the insurance company as part of the policy.

When taking out insurance, you can find many levels of coverage. For example, if you were to take out home insurance you could choose between building insurance or contents insurance. Building insurance would only cover the cost of repairing damage to the structure of your property, while contents in covers the cost of replacing your belongings in your home. Or you could opt for a buildings and contents policy which would provide insurance coverage for both.

Cash value

Whole life policies sometimes include a ‘cash value’, which is the amount that can be borrowed against or withdrawn from the policy while the policyholder is alive. With a whole life insurance policy, your premiums are invested during the lifetime of the policy. This builds up a ‘cash value’, which you can then withdraw or borrow against.

Death benefit

The term ‘death benefit’ refers to the payout that the beneficiary of a life insurance policy receives when the policyholder dies.

Claim

A claim is when you ask your insurance company to pay out on your insurance policy for a covered loss or policy event. Your insurance company will want to validate the claim. That is, they’ll check what you say happened, happened and assess the costs sustained. Once approved, the insurer will issue you a payment.

Beneficiary

When you take out a life insurance policy you will be asked to name a beneficiary. This is the person, or people, who will inherit the cash lump sum that the insurance company is required to pay in the event of your death.

Exclusions

When dealing with insurance, an ‘exclusion’ is a policy provision that eliminates coverage for some types of risk. For example, some travel insurance policies will have exclusions for unattended baggage or undeclared medical conditions. This basically means that the insurance company is not required to pay out if you have left your possessions unattended, or if you fall ill from a pre-existing medical condition that you haven’t declared.

Risk

Insurance risk is the possibility of loss, damage or injury against which the insurance is provided. It is essentially the threat covered by your insurance policy.

Term

Term is usually used in reference to life insurance policies. It refers to the amount of time your policy runs for, which is defined by you and your insurer when the policy is taken out. Insurers are required to pay out if you die during the term of the policy, but if you die after the term has expired there is no obligation for them to pay.

What are the types of insurance available?

You can find insurance for almost anything. Julia Roberts reportedly insured her smile to the tune of £19m! So it can be hard to know which insurance you need and what should be covered when you do take out a policy. Let’s take a look at those ‘mainstream’ insurance products that you are most likely to need in your adult financial life.

Home Insurance

There are different levels of coverage when you take out home insurance. It is one of the most popular insurance policies in the UK, and if you own a property it is a legal requirement to have buildings insurance.

Types of home insurance

What should be included

Buildings insurance

  • Cover for the cost of repairing damage to the structure of your property including garages, sheds, fences and the replacement of items such as pipes, cables and drains.
  • It should include the full cost of rebuilding your house.
  • Policies usually cover loss or damage caused by fire, storms, floods, earthquakes, theft, attempted theft, vandalism, frozen or burst pipes, fallen trees, lampposts, aerials or satellite dishes, subsidence and vehicle or aircraft collisions.

Contents insurance

  • Cover against the loss, theft or damage to your personal and home possessions.
  • It should cover damage caused by fire, flooding, storms and theft.
  • Most policies offer new for old cover, which means you get the full replacement cost of items that are lost, stolen or damaged.

Buildings & Contents insurance

  • Covers both the building and your possessions inside against damage, loss or theft.

These are the mainstream home insurance products, but there are more niche policies for properties such as listed buildings, or holiday homes.

Car insurance

If you drive a car, then you need car insurance — it’s the law. However, what level of cover you take out is up to you.

Types of car insurance

What should be included

Third party

  • Cover for someone else if you were to injure them or damage their property. It is the minimum level of cover you are legally required to have in order to drive a car in the UK.

Third party, fire and theft

  • Covers any damage to another person, their car or their property if you have an accident while driving.
  • Cover for your car in the event it is stolen, damaged or destroyed in a fire.

Comprehensive

  • Covers yourself and your car.
  • Cover for damage caused by fire, theft and vandalism, accidental damage caused by negligence, any personal injuries that result from an accident involving your vehicle when you were at fault and windscreen repair.
  • With comprehensive car insurance you are also likely to receive a courtesy car while your car is being repaired. 

Travel insurance

Have you ever fallen ill abroad? Or had something stolen? Then travel insurance would have had you covered. But as with other mainstream types of insurance, there are varying levels of cover.

Types of travel insurance

What should be included

Single trip travel insurance

  • Cover for a single trip over a set period of time.
  • This typically includes cover for injury and illness while abroad, emergency repatriation, flight and holiday cancellation or curtailment, delayed or lost luggage.

Annual multi trip travel insurance

  • Cover for multiple trips during a 12-month period.
  • Cover for medical expenses including repatriation costs, cancellation and delays, loss of baggage.

Worldwide travel insurance

  • Cover for travel worldwide.
  • Cover for medical expenses, transport issues and lost or stolen baggage.

We have detailed the most common types of travel insurance, but of course there are many other policies which are a bit more specialist. Examples include winter sports insurance or over 65s insurance (and yes, perhaps your smile if you’re Julia Roberts!). You can also get group insurance or family travel insurance in order to try to keep the cost of premiums down.

Life, critical illness, income and payment protection insurance

These insurance policies are designed to minimise the financial impact on your family if you were to die, become critically ill or are no longer able to work.

Types of protection insurance

What should be included

Life insurance

  • A lump sum or regular payments to your beneficiaries if you die.
  • Some policies provide a terminal benefit which will pay out on diagnosis of a terminal illness.

Critical illness insurance

  • A lump sum if you’re diagnosed with a defined critical illness during the policy term.
  • Illnesses that are typically covered include heart attack or stroke, loss of arms or legs and diseases such as cancer, multiple sclerosis or Parkinsons.

Income protection insurance

  • A percentage of your take-home pay if you can’t work due to illness or disability.
  • Covers most illnesses that leave you unable to work.

Payment protection insurance

  • Cover for credit card, loan or mortgage repayments if you have an accident, become ill and cannot work or become unemployed.

Private medical and dental insurance

While here in the UK we have the National Health Service (NHS), there is still the option to go private for your medical or dental needs if you so wish. Private medical or dental insurance can act as a supplement to what is available on the NHS and can sometimes be offered as part of your employee benefits package.

Type of insurance

What should be included

Private medical insurance

  • Cover for the cost of all or some of your medical bills if you pay for your own healthcare.
  • Cover for in-patient treatments and day-care surgery. Some policies will also cover out-patient treatments.

Dental insurance

  • Cover for routine check-ups and the cost of any dental work including dental accidents and emergencies.

Pet insurance

Pets often become part of the family so it is understandable that you would want to protect them. Pet insurance can provide you with peace of mind in case there is an accident or your pet falls ill.

Type of insurance

What should be included

Pet insurance

  • Covers the cost of veterinary treatment for your pet.

Group insurance

Group insurance is an insurance that covers a group of people that are part of a society or professional association, or the employees of a particular employer. By grouping individuals together insurance companies can often provide lower rates. Group insurance is typically offered for life insurance and health insurance, but can sometimes also apply to other types of personal insurance.

How do I apply for insurance?

You can apply for an insurance policy with the provider directly, through a comparison site or through an insurance broker.

Most providers will have details of their policies on their websites. If you apply online, on the phone or through a paper application, you will need to provide personal details and information about what it is you are insuring. So for example, if you are taking out car insurance, you will need to provide details about the car itself, details about how often you use the car and where it is kept overnight and details about your driving history. This all helps your insurer decide the level of risk and therefore what your premium will be.

You may want to consider buying an insurance policy through a comparison site, as sometimes you can make a saving. Try to check more than one site and understand that the cheapest option isn’t always the best. Look at the amount of excess you will be required to pay and always try to check that the policy has the right level of cover that you want.

If you are considering taking out an insurance policy for something you don’t know much about or if you are insuring something unusual, you may want to consider using an insurance broker. Here you will get expert advice, and your broker will have access to more specialist providers. Brokers typically won’t cost you any more than you’d otherwise pay, as, like comparison sites, they get paid commission by the insurance provider for selling their products.

What insurance is right for me?

Picking what insurance is right for you depends on your personal situation and your current financial needs. For example, if you are a homeowner who drives a car, you will need at least buildings insurance and third-party car insurance. But you may also want to take out life insurance or income protection insurance in order to make sure your mortgage gets paid if something were to happen to you.

If you are considering taking out a new insurance policy, it is a useful exercise to compare products. Consider comparing like for like, which means looking at what is covered and the different charges associated with the product. Thoroughly read the policy document so you know that the features that are included. And finally, try to answer your insurer’s questions to the best of your knowledge. Any inaccuracies and your policy might be cancelled or any future claim may be rejected.


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