How does insurance work?

Insurance is a financial product sold by insurance companies to safeguard you and / or your property against the risk of loss, damage or theft (such as flooding, burglary or an accident).
Some types of insurance have to be taken out by law, such as motor insurance if you drive a vehicle, while others are a contract condition, like building insurance when you have a home loan. Others are sensible, like life insurance or saving for a pension.
While it is a good idea to make sure you are not paying for insurance you don’t need, you should always think about what could happen if disaster struck and you didn’t have cover to protect you.
An insurance policy is the contract you take out with an insurer to protect you against specific risks under agreed terms.
How it works
When you buy a policy you make regular payments (known as premiums) to the insurer. If you make a claim, your insurer will pay out for the loss that is covered under the policy. If you don’t make a claim, you won’t get your money back; instead it is pooled with the premiums of other policyholders who have taken out insurance with the same insurance company. If you make a claim the money comes from the pool of policyholders’ premiums.
Different types
To determine what type of insurance you need, think about why you need cover; what you should include in your cover; how much you can afford; how long you might need cover for; and whether you want cover for yourself and / or for loved ones.
It’s relatively easy to buy insurance. You can either contact an insurer directly, online or over the phone; seek professional advice through an insurance broker; or speak to an independent financial advisor.
How premiums are calculated
Insurers use risk data to calculate the chances of the event you are insuring against happening. This information is used to work out the cost of your premium. The more likely the event you are insuring against is to occur, the higher the risk to the insurer and, as a result, the higher the cost of your premium.
An insurer will take two important factors into account when working out the premium they will charge, namely how likely is it that someone will need to make a claim, and is the person who wants to take out the policy a bigger or smaller risk than the “average” policyholder.
Only a proportion of policyholders will make a claim in any one year.
Standard conditions
Although policies have different terms and conditions, in general there are three main principles that are common across all insurance policies.
• That cover is provided for the actual value of the property or item that has been lost or damaged (its replacement value), but does not include any sentimental value;
• There needs to be a large number of similar risks so that the likelihood of a claim can be spread amongst other policyholders. It must be possible for insurers to calculate the chance of loss so that a premium can be determined; and
• That losses are not deliberate.