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How Does Insurance Work?


Insurance works by sharing risks among multiple premium payers and making significant losses due to an auto accident or natural disaster less devastating for individual households.

Ratemaking (or price-setting) is the actuarial science behind risk pooling. This process uses probability and statistics to approximate future losses and set rates accordingly.


Insurers collect premiums to cover the expenses incurred from paying out claims for damages, theft, lawsuits, and health care expenses. They do this by spreading risk among many policyholders.

State laws regulate insurance companies to ensure they have enough liquid assets (the total of all premiums collected) to cover potential claims from events like fires, storms, or auto accidents. Furthermore, insurance companies must determine how much to charge per policy by considering how likely certain losses are and analyzing claim histories and statistics to assess risk.

Factors that influence an individual’s risk include age, sex, driving history, employment status, hobbies, or other activities they engage in. Some policies, such as auto or home insurance, require that policyholders pay an upfront deductible before being covered against losses by insurers.

Most insurers allow policyholders to choose whether they’d like their premium payments made annually or monthly; annual installments generally have lower administrative costs for insurers, while monthly installments make budgeting for coverage more accessible. No matter which payment method people select, all premiums must be paid for coverage to remain active.


Insurance companies use the money you pay monthly as premiums to protect you from certain losses. Policies vary, but common examples include car accidents, kitchen fires, and illnesses. They generally collect enough premiums to remain solvent even if some claimants make claims; hopefully, those claims remain small and far between.

Once you and your doctor agree that a particular health care service is medically necessary, it becomes covered expense by insurance. Your insurer then negotiates a discount with the provider, so you have to pay less, known as being in the network. If you visit a provider not included within your network, however, then additional fees or meeting out-of-pocket maximums may apply; your health plan will send an Explanation of Benefits form detailing what was paid out on your behalf and any services they’ve covered as soon as they come due for payment from them to show what services have been covered under your plan.

Understanding how insurance works can help you make informed choices during open enrollment or when selecting coverage options. With all its acronyms, deductibles, copayments, and coinsurances, it can be easy to become overwhelmed when selecting coverage – watch our animation for a deeper dive into essential concepts like premiums, deductibles, and coverage options!


Deductibles are an integral component of health, auto, and home insurance policies and must be paid out-of-pocket before their insurance plan will pick up the bill for services rendered. They’re commonly seen when paying monthly premiums as well.

A deductible is designed to protect insurers from becoming too profitable, which could impede their ability to meet claims obligations when they arise. Therefore, it is crucial that you shop around, compare policies, and request quotes from multiple insurers to find one with the best rate that fits your unique circumstances.

Once a claim has been filed against you, coinsurance often applies. Often this represents a percentage of total costs; for example, after paying your deductible, you may be responsible for up to 20% of additional expenses incurred as part of treatment.

Insurance plans typically cover the remaining 80 percent. Insurance is a giant rainy day fund shared among many, helping cover losses they otherwise couldn’t afford. Insurance companies collect payments (known as premiums) from policyholders to create a pool of assets that meet liabilities when losses occur – this pool of money allows the entire concept of insurance to work since risk can be spread out among many people. It thus becomes relatively affordable for everyone to purchase it.


Insurance can provide protection from financial loss you cannot cover alone. In exchange for a monthly payment (known as a premium), you agree to let the insurance company cover specific losses specified in your policy – protecting you from car accidents, fires, health issues, or other financial catastrophes.

When something covered by your insurance occurs, filing a claim with your insurer and receiving payment as reimbursement for losses is indemnification. Insurance companies collect various types of data to help them establish how much to charge you; using probabilities and laws of large numbers, they calculate rates so that over time their claims payouts are less than the total premiums collected.

Insurance claims can have an enormous impact on your rates. Filing multiple claims could have the same effect; filing too many will likely increase premiums even when losses weren’t your responsibility. Insurance companies set their rates so they have enough funds available for payouts, expenses, and making a profit.