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How insurance works

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 floodingburglary or an accident).

Some types of insurance you have to take out by law such as motor insurance if you drive a vehicle; some you may need as a condition of a contract such as buildings insurance as a requirement of your mortgage; and others are sensible to take out such as life insurance or saving for a pension.

While it is a good idea to make sure you are not paying for insurance that you don’t need, you should always think about what would happen if disaster struck and you didn’t have cover to protect you.

You can buy insurance policies for many aspects of your life, for example for your health, home, car, business, or retirement.

An insurance policy is the contract that 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.

To decide on the type of insurance you need think about:

  • why you need cover
  • what you want to include in your cover
  • how much you can afford
  • how long you might need cover for
  • whether you want cover for yourself and / or for loved ones

To buy insurance cover you can:

How premiums are calculated

Insurers use risk data to calculate the likelihood 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.

  1. How likely is it in general terms that someone will need to make a claim?
  2. Is the person who wants to take out a policy a bigger or smaller risk than the ‘average’ policyholder (for example, a young person with a high-powered car may be charged a higher premium as they are statistically more likely to be involved in an accident than a mature, experienced driver)?

Only a proportion of policyholders will make a claim in any one year. 

Standard policy conditions 

Although policies have different terms and conditions, in general there are three main principles that are common across all insurance policies. These include:

  • 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 among other policyholders. It must be possible for insurers to calculate the chance of loss so that a premium can be set which matches the risk
  • losses must not be deliberate

For more information