Deductible
Insurance policies generally include an initial amount of expense that an insured person must pay when a loss occurs. This expense is known as the policy’s deductible. The deductible is the amount of loss a policyholder agrees to pay without protection from an insurance company.
Selecting a $500 deductible on auto insurance, for instance, equals an agreement to pay up to $500 for damage to a car in the event of an accident. Under such an agreement, the insurance company will pay for losses exceeding $500. Therefore, if someone holding such a policy has an accident costing $1000 to repair, the insurance company will pay $500 toward that repair.
The premium for an insurance policy varies according to the level of its deductible. For example, a policy with a $500 deductible costs less than one with a $250 deductible, because the lower the deductible, the more the insurance company has to pay for a loss.
Premium
An insurance company sets a policy’s premium by multiplying a rate for each unit of insurance coverage by the total amount of coverage being purchased. Assume, for example, that term life insurance for 35-year-old men has a rate of $1.10 for $1000 of coverage for one year.
Based on this rate, a 35-year-old father who wants $500,000 of coverage to protect his family in the case of his death will pay a premium of $1.10 times 500, or $550 for one year of coverage. Most people pay insurance premiums once or twice a year. Other people choose to make automatic monthly payments to their insurance company from a bank account.
Actuaries, experts in determining insurance rates, compute insurance rates using information not available to consumers. To compute rates, they first estimate expected losses in the coming year, based on statistics from previous years. Next they figure how much money will be needed to pay for those losses. They then divide that amount by the number of people needing insurance protection.
Consider, for example, the risks faced by 1000 people, each of whom just purchased a $25,000 car. Using statistics from past losses, an insurance company predicts that 10 of the 1000 cars will be destroyed in accidents during the next year, and 65 will be damaged. The company estimates that payments to cover the damage and destruction to these 75 cars will cost a total of $450,000. If the company collects $450 that year from each of the 1000 car owners, it should have almost exactly the funds it needs to cover those 75 out of 1000 car owners who experience losses.
In this example, each car owner would actually have to pay more than $450 to support part of the costs of the insurance company’s operations, leave some profit for the company, and leave some room for error in the company’s estimates. Also, 925 of the people who buy the insurance will have no accidents and will make no claims. Their payments will go to cover the losses of the 75 people who have accidents. But since none of the 1000 car owners knows whether or not they will have an accident, they each agree to pay the premium, even though it may go toward paying for a portion of someone else’s losses.
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