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

What Is Insurance?

Insurance is a contract, represented by a policy, in which a policyholder receives financial protection or reimbursement against losses from an insurance company. The company pools clients’ risks to make payments more affordable for the insured. Most people have some insurance: for their car, their house, their healthcare, or their life.

Insurance policies

hedge against financial losses resulting from accidents, injury, or property damage. Insurance also helps cover costs associated with liability (legal responsibility) for damage or injury caused to a third party.

Key Takeaways

  • Insurance is a contract (policy) in which an insurer indemnifies another against losses from specific contingencies or perils.
  • There are many types of insurance policies. Life, health, homeowners, and auto are among the most common forms of insurance.
  • The core components that make up most insurance policies are the premium, deductible, and policy limits.

How Insurance Works

Insurance is available to help you pay for damage to your property or to pay others on your behalf when you injure someone or damage their property. Insurance is a contract that transfers the risk of financial loss from an individual or business to an insurance company. They collect small amounts of money from clients and pool that money together to pay for losses.

Insurance is divided into two major categories:

  • Property and Casualty insurance (P&C)
  • Life and Health insurance

Property and casualty insurance provides protection to businesses and individuals for losses related to their belongings or assets, both physical and financial. Life and health insurance protects people from financial loss due to premature death, sickness or disease.

Insurance uses probability and the law of large numbers to determine the cost of insurance premiums it charges clients based on various risk factors. The rate must be sufficient for the company to pay claims in the future, pay its expenses, and make a reasonable profit, but not so much to turn away customers. The more likely an event will occur for a given client, the more insurance companies will need to collect to pay the anticipated claims.

Insurers market their products and services to consumers in different ways. The price companies charge for insurance coverage is subject to government regulation. Insurance companies may not discriminate against applicants or insureds based on a factor that does not directly relate to the chance of a loss occurring.

Insurance Policy Components

An insurance policy/plan is a legal agreement between a person (Policyholder) and an insurance firm (Provider). Under the terms of the contract, you pay the insurer regular sums of money (premiums), and they cover your losses if an unpleasant event occurs, such as the early death of the life insured, an accident, or property damage. Let's take a closer look at what insurance is and the numerous advantages, features, and kinds of insurance available in India.

In the event of a claim, the insurer pays the policyholder/nominee a lump sum payment based on the insurance conditions.

Individual requirements and life objectives guide the selection of a certain type of insurance coverage.

A thorough grasp of the many components of an insurance policy can aid you in selecting the plan that is most suited to your needs.

Components of Insurance

To help you better grasp 'what is insurance' and how it works, below are some of these components :

Insurance Premiums

An insurance policy's premium is the amount you must pay to obtain a specified quantity of insurance coverage. It's usually described as a recurring fee that you pay as a lumpsum, or on a monthly, quarterly, half-yearly, or annual basis during the premium payment period.

An insurance firm determines the premium of an insurance plan depending on a number of criteria. The goal is to determine if an insured person is eligible for the type of insurance plan he or she want to purchase.

For example, suppose you are fit and have no medical history of receiving treatment for serious physical disorders. In that case, you will likely be paying less for medical insurance or life insurance than those who have many ailments.

You should also be aware that for comparable products, various insurance providers may charge varying prices. As a result, finding the correct one at a reasonable price takes some time and effort.

Policy Restrictions

It is defined as the maximum amount for which an insurance company is responsible for losses covered by the policy. It is calculated depending on the insurance term, loss or damage, and other comparable criteria.

Typically, the greater the policy limit, the greater the premium. The sum assured is the maximum amount that an insurer will pay to the nominee under a life insurance policy.


The amount or percentage that the insured decides to pay out of pocket before the insurer steps in to settle a claim is referred to as the deductible.  The insurance company is liable to pay the claim amount only when it exceeds the deductible.

Deductibles are determined by the provisions of a certain type of policy and are applicable per policy or per claim. In general, insurance policies with large deductibles are less expensive since fewer claims are filed due to the greater out-of-pocket price.

Policy Limit

The policy limit is the maximum amount an insurer will pay for a covered loss under a policy. Maximums may be set per period (e.g., annual or policy term), per loss or injury, or over the life of the policy, also known as the lifetime maximum.

Typically, higher limits carry higher premiums. For a general life insurance policy, the maximum amount that the insurer will pay is referred to as the face value. This is the amount paid to your beneficiary upon your death.

The federal Affordable Care Act (ACA) prevents ACA-compliant plans from instituting a lifetime limit for essential healthcare benefits such as family planning, maternity services, and pediatric care.


The deductible is a specific amount you pay out of pocket before the insurer pays a claim. Deductibles serve as deterrents to large volumes of small and insignificant claims.

For example, a $1,000 deductible means you pay the first $1,000 toward any claims. Suppose your car's damage totals $2,000. You pay the first $1,000, and your insurer pays the remaining $1,000.

Deductibles can apply per policy or claim, depending on the insurer and the type of policy. Health plans may have an individual deductible and a family deductible. Policies with high deductibles are typically less expensive because the high out-of-pocket expense generally results in fewer small claims.

Types of Insurance

There are many different types of insurance. Let’s look at the most important.

Health Insurance

Health insurance helps covers routine and emergency medical care costs, often with the option to add vision and dental services separately. In addition to an annual deductible, you may also pay copays and coinsurance, which are your fixed payments or percentage of a covered medical benefit after meeting the deductible. However, many preventive services may be covered for free before these are met.

Health insurance may be purchased from an insurance company, an insurance agent, the federal Health Insurance Marketplace, provided by an employer, or federal Medicare and Medicaid coverage.

The federal government no longer requires Americans to have health insurance, but in some states, such as California, you may pay a tax penalty if you don't have insurance.

If you have chronic health issues or need regular medical attention, look for a health insurance policy with a lower deductible. Though the annual premium is higher than a comparable policy with a higher deductible, less-expensive medical care year-round may be worth the tradeoff.

Home Insurance

Homeowners insurance (also known as home insurance) protects your home, other property structures, and personal possessions against natural disasters, unexpected damage, theft, and vandalism. Homeowner insurance won't cover floods or earthquakes, which you'll have to protect against separately. Policy providers usually offer riders to increase coverage for specific properties or events and provisions that can help reduce deductible amounts. These adders will come at an additional premium amount.

Renter's insurance is another type of homeowners insurance.

Your lender or landlord will likely require you to have homeowners insurance coverage. Where homes are concerned, you don't have coverage or stop paying your insurance bill your mortgage lender is allowed to buy homeowners insurance for you and charge you for it.

Auto Insurance

Auto insurance can help pay claims if you injure or damage someone else's property in a car accident, help pay for accident-related repairs on your vehicle, or repair or replace your vehicle if stolen, vandalized, or damaged by a natural disaster.

Instead of paying out of pocket for auto accidents and damage, people pay annual premiums to an auto insurance company. The company then pays all or most of the covered costs associated with an auto accident or other vehicle damage.

Auto insurance pays for injuries or property damage after an accident, at least up to the policy’s limits. That financial protection is why insurance is usually required by state law in order to own or drive a car.

Medical bills and car repair costs can add up when multiple vehicles and drivers are involved, which can quickly become overwhelming. And because the cost of car insurance depends on many different factors (like where you live and what kind of car you drive), it can be difficult to understand how much you’ll pay and how much coverage you’ll need. All of this means that shopping for the right insurance can be difficult for anyone.

Life Insurance

Life Insurance - Meaning

Life Insurance can be defined as a contract between an insurance policy holder and an insurance company, where the insurer promises to pay a sum of money in exchange for a premium, upon the death of an insured person or after a set period. Here, at ICICI Prudential Life Insurance, you pay premiums for a specific term and in return, we provide you with a Life Cover. This Life Cover secures your loved ones’ future by paying a lump sum amount in case of an unfortunate event. In some policies, you are paid an amount called Maturity Benefit at the end of the policy term.

There are two basic types of Life Insurance plans -

  1. 1. Pure Protection
  2. 2. Protection and Savings


What is Pure Protection Plan?

A Pure Protection plan is designed to secure your family’s future by providing a lump sum amount, in your absence.

What is Protection and Savings Plan?

A Protection and Savings plan is a financial tool that helps you plan for your long-term goals like purchasing a home, funding your children’s education, and more, while offering the benefits of a Life Cover.

Click here to know more about different types of Life Insurance Plans.

Factors that affect life insurance premium

Now that you know what is life insurance and why you need it, find out the factors that can affect the life insurance premium:

  • Age:

    One of the prime factors that affect the premium for a life insurance plan is your age. The life insurance premium is lower for younger people and gradually increases with age
  • Gender:

    Studies have shown women live longer than men1. Therefore, the life insurance premium is lower for women as compared to men
  • Health conditions:

    Your present and past health conditions can determine the premium for your life insurance plan. If you have any pre-existing illnesses or have suffered from an illness in the past that may resurface or affect your present health, you would be charged a higher premium
  • Family health history:

    The chances of suffering from a disease that runs in your family are considerably high. So, if any hereditary illnesses run in your family, you may have to pay a higher premium
  • Smoking and drinking alcohol:

    Lifestyle habits like smoking and drinking alcohol can impact your health and lead to multiple health issues. Therefore, insurance companies charge a high premium for individuals who smoke or drink alcohol
  • Type of coverage:

    The type of coverage you opt for can increase or decrease the life insurance plan’s premium. If you add any riders to your plan, the premium would increase. A longer policy term can also result in a higher premium compared to a shorter term. In addition to this, the type of life insurance plan you select also impacts the premium. For instance, term life insurance is the most affordable form of life insurance
  • Amount of coverage:

    A higher sum assured would result in a higher premium and vice versa
  • Occupation:

    If you work in a high-risk job, the premium for your life insurance plan would be higher than others. For example, if you work in construction or if your job puts you at any kind of risk, such as regular exposure to chemicals, the insurance company will charge a higher premium

Travel Insurance

Travel insurance covers the costs and losses associated with traveling, including trip cancellations or delays, coverage for emergency health care, injuries and evacuations, damaged baggage, rental cars, and rental homes. However, even some of the best travel insurance companies do not cover cancellations or delays due to weather, terrorism, or a pandemic. They also don't often cover injuries from extreme sports or high-adventure activities.

What Is Insurance?

Insurance is a way to manage your financial risks. When you buy insurance, you purchase protection against unexpected financial losses. The insurance company pays you or someone you choose if something bad occurs. If you have no insurance and an accident happens, you may be responsible for all related costs.

Why Is Insurance Important?

Insurance helps protect you, your family, and your assets. An insurer will help you cover the costs of unexpected and routine medical bills or hospitalization, accident damage to your car or injury of others, and home damage or theft of your belongings. An insurance policy can even provide your survivors with a lump-sum cash payment if you die. In short, insurance can offer peace of mind regarding unforeseen financial risks.

Is Insurance an Asset?

Depending on the type of life insurance policy and how it is used, permanent or variable life insurance could be considered a financial asset because it can build cash value or be converted into cash. Simply put, most permanent life insurance policies have the ability to build cash value over time.

The Bottom Line

Insurance helps to protect you and your family against unexpected financial costs and resulting debts or the risk of losing your assets. Insurance helps protect you from expensive lawsuits, injuries and damages, death, and even total losses of your car or home.

Sometimes, your state or lender may require you to carry insurance. Although there are many insurance policy types, some of the most common are life, health, homeowners, and auto. The right type of insurance for you will depend on your goals and financial situation. requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Consumer Financial Protection Bureau. “What Is Insurance?

  2. U.S. SBA. "Get Business Insurance."

  3. Ohio Department of Insurance. "How Insurance Rates are Determined."

  4. "Lifetime & Annual Limits."

  5. "Preventive Health Services."

  6. State of California Franchise Tax Board. "Individual Shared Responsibility Penalty Estimator."

  7. CFPB. "What is Homeowner's Insurance? Why is Homeowner's Insurance Required?"

  8. CFPB. "What is Force-Placed Insurance."

  9. Texas Department of Insurance. "Do You Need Life Insurance?"

  10. Centers for Disease Control. "Travel Insurance, Travel Health Insurance & Medical Evacuation Insurance."

  11. "Variable Life Insurance."

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