This post is part of the textbook personal finance series which covers basic personal finance skills by going through an actual textbook, chapter-by-chapter. Check out the intro post for more information.
Moving on from Consumer Credit, I’ve skipped past the two chapters on buying a car and a home because there is a lot written about them online and some of it does a better job of covering modern concerns.
Instead, I’m moving on to Chapter 8 on Home and Automobile Insurance. Insurance is talked about a lot, but this chapter has a great introduction to the concept of insurance and the terms and elements involved.
What is Insurance?
In short, insurance is protection against possible financial loss. The financial loss can be of property, income, ability, etc. While the loss may not only be financial, insurance only provides financial compensation so that you can rectify the situation as much as possible.
The insurance company (insurer) is a risk-sharing business. When you purchase a policy from them (and become a policy-holder), the insurance company agrees to take on the risk in exchange for a fee (premium). They then provide insurance coverage for a specified thing for a specified period.
Types of Risk
You face risks every moment of every day. You could hurt your back getting out of bed (just happened to a coworker), get hit by a careless driver, slip on a brick on your way to work and tear a ligament in your foot (happened to me), have your ceiling fall in, get robbed…just to mention a few.
Insurance companies use three words to describe and clarify risk—”risk,” “peril,” and “hazard.” We might use them interchangeably, but they don’t mean the same thing.
Risk is the chance of loss or injury.
Peril is anything that may possibly cause a loss or injury. Peril is what you’re insuring yourself against. You may buy insurance against car accidents or against flooding. Getting insurance for your car (the object at risk) doesn’t mean you have insurance against everything that could happen to it, just the things in your policy.
Hazard is anything that increases the likelihood of loss through peril. This could be bad brakes, poor wiring in your house, a history of illness (for health insurance), etc.
There are three kinds of risk you might insure against—personal risks (loss of income, life, or money due to illness, disability, loss of employment, etc), property risks (losses of property or property value), and liability risks (losses caused by negligence which cause injury or property damage).
Those three risks can be insured against and the insurance company will only have to pay if something happens. These are accidental and unintentional risks.
Speculative risks like starting your own business can’t be insured against since you’re taking a calculated chance in hope of gain rather than trying to prevent loss if something accidentally happens.
Next week, we’ll talk about methods of managing risk and planning your insurance coverage.