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What is Insurance and How it Works

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What is Insurance and How it Works

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An unexpected accident. An earthquake, a flood, a fire, or a sudden death in the family — these risks, and many more, are all an unavoidable part of life. And they almost always come with huge financial outlays. Here’s where insurance can help.

It’s not possible to estimate the exact cost of dealing with such incidents. For instance, you cannot predict beforehand how much damage an accident may cost to your vehicle. Or foresee what illnesses you may develop later in life and what the cost of treating such a condition may be. But insurance helps you be better prepared for these contingencies. 

That said, what is insurance anyway? And how does it work? If these are some of the questions on your mind, let me take you through this financial concept.

What is insurance?

Insurance is a financial contract between two parties, namely the insured party (that’s you) and the insurance service provider (or the insurer). Here, the insurer agrees to pay you a specified sum of money in case of certain contingencies. 

These contingencies are incidents that result in financial losses or expenses, which you will have to bear in case you are not insured. But with an insurance policy in your portfolio, you pass on this risk to the insurance service provider. 

In return for this service, you need to pay the insurer a specific sum of money, known as the insurance premium. The premium is determined by various factors, depending on the kind of insurance we’re talking about. 

How does insurance work?

The exact manner in which insurance works varies from one kind of insurance to another. We’ll get into those details in a bit. But broadly speaking, here’s how this financial product works. 

  • Deciding on the type of insurance

The first step in the process of how insurance works revolves around deciding what you want to insure and what kind of policy you want to buy. There are different assets that you can insure, like your life, your car, your home or your health too. We’ll see more about this in the later sections of this article.

  • Purchasing your policy

Once you’ve decided on the type of insurance plan you want to purchase, you need to fill out the application form and submit it along with the required documents to your insurance service provider. This can be done online or offline. You can even choose to get a quote before you actually buy your policy, so you can get a better idea of what it costs.

  • Paying your premiums

Once you’ve purchased your insurance plan, you need to pay the first instalment of the premium right away. If your plan requires a one-time premium payment, you need to pay the cost upfront. And if the policy requires periodic premium payments, you need to pay the cost as and when it’s due. 

  • Raising a claim

As long as you pay your premiums on time, your insurance policy will remain active. And if any of the contingencies covered by your policy occur, you can raise a claim with your insurance provider. The insurer will then evaluate the validity of your claim and make the payouts due under the policy accordingly.

What are the different types of insurance we have in India?

There are different kinds of risks in life. And a variety of assets that need to be protected. So, given this variation, we also have different types of insurance plans in India. Broadly speaking, insurance can be classified as life insurance and general insurance. Anything that does not fall under the category of life insurance is classified as general insurance. 

Here’s a general overview of the 5 most common kinds of insurance you will typically need. 

  • Life insurance

In life insurance, the asset you insure is your life. Here, in case of your demise, the insurer pays out the sum assured under the policy to your nominee/beneficiary. This kind of insurance has been designed to ensure that in your absence, the people who are financially dependent on you are not left without any safety net. 

  • Health insurance

Next to your life, your health is perhaps the greatest asset you own. And a health insurance plan helps you insure this valuable possession. It also ensures that you are not burdened by the rising costs of healthcare. In case you are hospitalised or diagnosed with any of the illnesses covered, the insurer settles part or all of your medical bills based on the policy’s terms and conditions.

  • Motor insurance

As you may have guessed from the name, motor insurance is a cover taken on your vehicle, typically your car or your two-wheeler. With a motor insurance plan in place, you need not worry about the steep costs of repairing or replacing your car, bike or scooter in case it’s damaged in an accident or stolen. 

  • Travel Insurance

Travelling is all fun and games until your flight is delayed, your baggage is lost, or you face a sudden medical emergency when you’re far from home. Fortunately, with a travel insurance plan, you can rest assured that the financial repercussions of these emergencies are taken care of by your insurance provider.

  • Home Insurance

If you are a homeowner, you will no doubt agree that maintaining a house is no easy task. But apart from regular upkeep and maintenance — which you can plan in advance — you also need to be prepared for unexpected costs like sudden repairs or losses in case of theft. Here’s where home insurance can help. It covers the financial losses or expenses in such situations.

Well, this should have given you a very brief overview of what each kind of insurance is primarily useful for. But you will undoubtedly have more questions than answers at this point. 

Questions such as —

  • What is life insurance?
  • What is health insurance?
  • What are the other types of insurance?
  • How do they work?

Let’s take a deep dive into each kind of insurance, so you can get a better idea of what they entail and how they work.

A sneak peek into life insurance

Life insurance is one of the most fundamental kinds of insurance covers we have. In fact, the entire insurance market can be divided into life and non-life insurance. And although there are different types of life insurance plans, all life covers fundamentally work in the same manner — they insure your life.

Every life cover is valid for a specific period of time, known as the policy term. In case the insured person passes away during this period, the insurance provider will pay out a guaranteed sum, known as the sum assured, to the nominee mentioned in the plan. This financial payout is known as the death benefit, and it can help the surviving members of the affected family take care of their basic needs and fulfil their life goals. 

Apart from this key benefit, life insurance plans can also offer other advantages. Based on this, we have different types of life insurance, as you’ll see below. 

Types of life insurance plans and how they work

To understand how each kind of life insurance works, we’ll need a hypothetical example. So, let me introduce you to Rohit. Here are some key details you should know about him. 

  • He’s 30 years old, he’s married, and he has a daughter. 
  • He wants to purchase a life insurance plan, with a sum assured of Rs. 50 lakhs.
  • He wants to remain insured till the age of 60. 
  • He nominates his spouse under his life insurance plan.

Now, Rohit can choose from the following different kinds of life insurance plans. Let’s take a closer look at how they work.

  • Term insurance:

This is the most affordable kind of life insurance because it offers only a pure life cover. Let’s assume Rohit opts for this kind of plan. If he dies before the age of 60, his insurance service provider will pay the sum assured under the plan to his spouse (aka the nominee).

But if he survives the policy term of 30 years, he will not get any maturity benefits. Except if he opts for the Return of Premium (ROP) option, in which case he will get his premiums back at the end of the policy term.

  • Endowment plans:

Now, let’s say Rohit is not happy with having just a life cover. He wants something more at the time of maturity. So, he opts for an endowment plan ,which offers the dual advantage of savings and insurance. 

Here, if Rohit survives till the age of 60, he will get a guaranteed maturity benefit at the end of the policy term. He can use this payout to meet his life goals at that stage of life, whatever they may be.

  • Unit Linked Insurance Plans (ULIPs):

Let’s say Rohit is a bit of a risk-taker. He wants more than just savings — he wants to create wealth with his life insurance plan. In that case, a ULIP is more suited to his financial goals. 

In this kind of life insurance, apart from a life cover, Rohit can also invest in different market linked ULIP funds like debt, equity or hybrid funds. When the policy matures 30 years later, he can withdraw his investments, which may have grown exponentially depending on how he invested his money.

  • Child insurance plans:

You’ll recall that Rohit has a daughter, right? In this scenario, let’s say he wants to save up for the major milestones in his child’s life, like her higher education and her wedding. 

So, Rohit opts for a child insurance plan. In addition to a life cover, it gives him guaranteed payouts that he can use to fund his daughter’s college education or her wedding. He can time the insurance policy in such a way that the payouts align with these milestones.

  • Retirement plans:

Rohit plans to retire at 60. So, he can also choose a retirement plan, which will offer him periodic payouts each month, once he attains 60 years of age. The payouts from such a plan can replace his active income after he retires. This kind of life insurance plan is also known as an annuity plan. 

A sneak peek into health insurance

Health insurance covers the cost of medical treatment, healthcare, and other related expenses. In case the policyholder is diagnosed with any of the illnesses covered, or if they need any emergency hospitalisation, a health insurance plan ensures that they do not need to spend most or all of their medical bills out of pocket. 

Rohit knows this, and he is a cautious person. He doesn’t just want to ensure that his wife and daughter are financially secure in his absence. He also wants to make sure he is adequately insured in case he falls ill when he’s older or if anyone in his family needs urgent medical care. So, he decides to get a health insurance plan. 

Let’s see what his primary options are and how they work.

Types of health insurance plans and how they work

Depending on who is covered by a policy, health insurance can be of two types — individual plans and family floater plans. Check out how they work.

  • Individual health insurance plans:

If Rohit wants to get a cover just for himself, this is the kind of plan he should opt for. Let’s say he does. In that case, he needs to pay the premiums charged by the insurer as per the premium payment schedule. The premium depends on several factors, like Rohit’s age, health status, family medical history and more.

Each year, Rohit will have to renew his health insurance policy. And he does so for about 4 years when he is unexpectedly hospitalised with a minor illness. Fortunately, it is covered by his health insurance plan. So, he can raise a claim on his policy in any of the following two ways:

A reimbursement claim

Here, Rohit has to first pay his medical bills out of pocket. Then, he can raise a claim on his policy and send the bills to the insurer. After due verification, the insurer will reimburse these expenses to Rohit.

A cashless claim

Here, Rohit does not have to pay anything (except the deductible) out of pocket. The deductible is the minimum amount that he should pay before his insurance benefits kick in. For more clarity, let’s say his hospital bills come up to ₹50,000, but his deductible is ₹10,000. This means Rohit has to pay ₹10,000 out of pocket. 

The health insurance service provider will automatically pay the rest of the bill (i.e. ₹40,000) on behalf of Rohit to the hospital. This facility is only available in network hospitals which have partnered with the concerned insurance provider. 

  • Family floater health insurance plans:

Family floater plans work pretty much like individual health insurance plans. The only difference is that the policy covers more than just one person. It is for an entire family. If Rohit wants to cover his wife and child as well under a health insurance plan, he can opt for this kind of cover. 

A sneak peek into motor insurance

Motor insurance is a broad term. Depending on the kind of vehicle covered, it can be car insurance or two-wheeler insurance. And it protects your car, bike or scooter in case of any loss or damage to the vehicle. It also covers different kinds of liabilities that may arise in case your vehicle is involved in an accident or in case it is damaged due to a natural or a man-made disaster. 

Types of motor insurance plans and how they work

Turning our attention back to Rohit, we find that he owns a family car, he drives a bike, and his wife drives a scooter of her own. Being financially prudent like he is, Rohit decides to get motor insurance plans for these vehicles. 

Here are his options and the details of how they each work.

  • Third-party liability insurance 

The Motor Vehicles Act 1988 makes this kind of motor insurance mandatory. It comes in handy in case of any third party liabilities that may arise due to an accident. For instance, say Rohit’s car is involved in an accident, and it accidentally damages another person’s vehicle. In this case, Rohit will have to compensate the victim for the damage.

But with a third party liability cover, he does not need to pay these dues out of pocket. His motor insurance service provider will take care of these liabilities. 

  • Comprehensive insurance 

Comprehensive motor insurance is not mandatory. But it offers wide-ranging protection to the vehicle that is insured. Take the example discussed above. If Rohit’s car is also damaged in the accident, his third-party cover will not be enough to cover the cost of repairs. 

But with a comprehensive insurance policy, he need not worry about restoring his car to its original condition. That’s because, in addition to a third-party cover, a comprehensive motor insurance plan also offers coverage for damages to the policyholder’s own vehicle. Plus, it may also cover the death of the driver and/or passengers. 

A sneak peek into travel insurance

Have you ever lost your baggage at an airport? Or has your flight been delayed or cancelled, leading to unexpected losses or expenses? Or perhaps, you’ve fallen sick during a vacation? If you’re a frequent traveller (and even if you’re not), chances are, you’ve probably experienced one or more of these scenarios.

Travel insurance is a financial product that is specifically designed for the risks that travelling entails. It covers different kinds of contingencies that may occur during your journey or while you are at the destination.

Types of travel insurance plans and how they work

To better understand how travel insurance works, let’s take the help of Rohit’s example once more. He is a frequent traveller — he travels for work and for leisure. And on many of his trips, he takes his family along. Depending on his travel itinerary and his destination, he has different insurance options to choose from.

Check out what they are and how they work.

  • Domestic travel insurance 

Say Rohit is travelling with his family from Mumbai to Kolkata. This is a domestic trip, so a domestic travel insurance plan should be enough. He purchases this kind of a policy, and when he lands in Kolkata, he finds that his checked-in baggage is missing. The airline informs him that it will take a couple of days to be redirected to Kolkata.

So, in the meantime, Rohit and his family will have to buy their essentials locally. These out-of-pocket expenses could be an unexpected burden. But thankfully, Rohit’s travel insurance plan ensures that his insurer reimburses him for these expenses. 

Similarly, a variety of other contingencies may also be covered under this kind of policy. Here’s a preview.

  • Medical expenses due to an accident or sickness 
  • Baggage delay
  • Loss of checked-in baggage
  • Loss of passport
  • Flight delay
  • Hijack
  • Trip cancellation by the airline
  • Personal accident cover, which covers the death or the permanent total disability of the insured person
  • International travel insurance 

An international travel insurance plan works much like a domestic travel insurance policy. The key difference is that it is taken for international travel only.

  • Multi-trip travel insurance 

Regular travel insurance is typically valid for a very short period, from a few days to a few weeks. But multi-trip travel insurance offers longer coverage, generally up to a year. 

If Rohit opts for this since he is a frequent traveller, he need not get a separate insurance plan each time he travels during the year. Aside from this key difference, a multi-trip plan works pretty much like a single-trip plan. 

A sneak peek into home insurance

The home insurance market may still be quite nascent in India, where we have a sizable population of renters. Nevertheless, if you own a house, it is always a good idea to get a home insurance plan as early as you can. 

A home insurance policy covers various risks that are associated with your house. This includes the following contingencies —

  • Loss or damage to the structure due to natural disasters like earthquakes, floods, storms, cyclones etc.
  • Damage due to an aircraft
  • Damage due to an explosion
  • Damage due to strikes or riots
  • Loss or damage to the contents or belongings in the house due to burglary or terrorism

How home insurance works

Let’s continue with the example of Rohit once more to understand how home insurance plans work. Rohit purchases a cover for his Mumbai home, and it is a comprehensive plan that covers both structural damages as well as loss of belongings.

Each year, he pays the renewal premium as needed, and fortunately, for the first 7 years, things are good. But then, during a particularly heavy monsoon season, his house is inundated by water, and it sustains a lot of damage that needs to be addressed and rectified sooner than later.

So, Rohit files a claim with his insurance provider. After assessing the damage, the insurer settles the claim with the necessary payout. Rohit then uses these funds to repair his house and restore it to its original condition. 

This is how home insurance works. It’s fairly straightforward and simple.

Summing up

All of this goes to show that fundamentally, all kinds of insurance work in a similar manner. They cover certain specific contingencies. And if the covered incident or loss occurs, the insurance provider steps in and covers the financial costs associated with the contingency. In return for taking over the risk, these insurance providers charge a premium from the insured parties. Once you understand this basic idea, you’ll be able to appreciate better how important insurance is. 

Without the necessary kinds of insurance covers, you may find that your hard-earned savings could be quickly eroded by an unexpected emergency. But when you have the essential kinds of insurance plans in your portfolio, you can go ahead and save for your other financial goals without any worries.

Frequently Asked Questions (FAQs)

What are the 4 types of insurance?

There are more than 4 types of insurance. But broadly speaking, the most common kinds of general or non-life insurance includes health insurance, home insurance, travel insurance and motor insurance.

What is insurance and what is its purpose?

Insurance is a contract between an insured person and an insurance provider. Here, the insurance provider agrees to compensate the insured person in case of certain contingencies. In return, the insured party has to pay a premium to the insurance service provider. 

Insurance is important because it helps you keep your savings and investments intact. It ensures that in case of an emergency, your insurance provider bears and covers the losses while your finances remain unaffected.

What are the benefits of insurance?

Depending on the kind of insurance, there are various benefits that you can enjoy. Here is a preview of the top benefits of insurance —

  • It helps you be better prepared for financial contingencies
  • It transfers the financial risk from you to your insurance service provider
  • It helps protect your loved ones
  • It helps protect and restore your assets
  • It shields you from the effect of inflation to a certain extent

Why is insurance needed?

Insurance is necessary because it protects you from the financial repercussions of unexpected incidents in life. In the absence of insurance, you may have to spend most or all of your savings on taking care of a contingency like a medical emergency in your family, a sudden home repair, or loss of valuable belongings due to theft.

But insurance helps you keep your investments untouched even if such an emergency comes to pass because your insurance provider takes care of these expenses for you. 

What is insurance risk?

Insurance risk is the probability that the contingency or the event covered by an insurance plan may occur. It is a risk because if the insured incident occurs, the insurance service provider will have to pay the amount due under the insurance contract.

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