InsuranceBy Richard Okumoto & Jackie Snell

What is insurance? How does insurance work? What should you protect? What basic insurance terms should you understand? What should you know about buying insurance?

What is Insurance?Personal insurance is a financial arrangement with two fundamental characteristics:

1. The risk of loss is spread across a group of people versus one individual.

2. Losses are shared by all the members within the group.

We all know that some people will experience a car accident in the next year. It will cost money, maybe a lot, and may even cause injuries. We just don’t know who. As a community we are each willing to pay a few hundred dollars into a fund to help defray the costs, both for property and medical care, for the unlucky few. (Well, we’re probably thinking more about getting our losses covered if we are one of the unlucky few.)

Before reading the remainder of this paper, please familiarize yourself with insurance terms listed in the section, “What Basic Insurance Terms Should You Understand.” This should add clarity to the reading.

How Does Insurance Work?Insurance is a form of legalized gambling. The insurance company is betting that they can charge each customer just a little bit more, when added up across all customers, than it costs to pay claims and run the company. They invest the money they are holding, which also helps to offset costs. You are betting a little bit of money, relatively speaking, so that, just in case you have an accident, you won’t be financially ruined.

Insurance companies keep very finely tuned records, called actuarial records, of who is likely to have an accident, based on many factors, like how old you are. Young people are more likely to have accidents because of having less experience and because the young are generally less sensitive to their own vulnerability. The elderly are more likely to have accidents because of failing sight and hearing and because of slowing reaction times. People who buy sports cars are more likely to drive fast and to make risky maneuvers than people who buy Volvos. Insurance companies hire sophisticated statisticians called actuaries, to analyze the actuarial records.

The insurance company determines whether or not a loss is insurable. Insurable means the company can reasonably expect to make money on a policy covering that kind of loss. Cars are insurable because, as long as the company has a large enough customer base, they can pretty well predict how many, and how expensive, the accidents for a year will be, and charge enough for a profit. After the 1989 earthquake in the S.F. Bay area, most insurance companies decided earthquakes weren’t something they wanted

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to bet on. For a time people in the bay area couldn’t buy earthquake insurance. The state of California had to step in to design a viable plan for earthquake insurance and then force insurance companies to participate. Until the new healthcare act becomes effective, most people with pre-existing conditions are uninsurable.

What Should You Protect?

You and Your Family:

Life Insurance protects members of your family against financial loss, or at least some of it, if you die. The breadwinners in a family should be insured if they have children. A stay-at-home parent might also be insured, if the family would incur financial hardship to hire day-care and other services required should that parent die.

There are many options available, but the basic idea is that you sign a contract with the insurance company agreeing to pay a certain amount each year. In return the company agrees to pay your family a certain amount per year, if you die, and usually for a specific amount of time. A family might choose a contract with a 20-year term when their first child is born, because they expect the child will no longer be dependent on them by the time he or she is 20. This kind of policy is called term life insurance because at the end of the term, in this case 20 years, the contract is over. If the family hadn’t gotten around to buying life insurance until the child was 10 years old, they would probably buy a policy with a 10 year term – lasting until the child is 20. Insurance contracts are called policies.

There are four parties to a life insurance policy: the insurance company, the insured, the owner, and the beneficiary. The owner is the person who pays for the policy. The insured is the person who has to die for the to claim the money. Often the insured is also the owner of the policy, except in movies where the beneficiary ALWAYS buys the policy (is the owner) and then murders the insured! Of course you don’t have to be planning a murder to insure someone else’s life, a married couple might choose to insure each other, or one person might hold all three titles. The reasons for choosing among the schemes are complicated. If you are insuring for large sums you should consult a tax attorney and or accountant.

Besides term insurance the other basic type of life insurance is called “whole life” or “universal life” insurance. It is in effect until you die, no matter how long that is. If you die at 102 your spouse or children will still get the money. Just remember, you have to keep paying until you are 102, too. As you can imagine, this type of insurance is more expensive than term insurance. The insurance company knows it will have to pay out eventually! For most people it is better to buy term insurance and invest the rest of the money they would have given the insurance company – maybe in something safe like bonds.

Health Care Insurance covers the medical costs if you become ill. There are many different policies, each with different rules about what it covers. When

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choosing a policy, it is important to understand what illnesses and procedures are NOT covered. You may have direct responsibility for uncovered expenses.

Recent health care has been transitioning to Managed care plans. Managed care plans typically focus on preventative measures such as routine physical exams to diagnose and recommend early stage treatments. Not only is this better for the patient, but also cheaper for the insurance company. There are many forms of Managed care plans, but two basic forms currently dominate:

HMO – Health Maintenance Organizations provide medical services to its members for a fee. Typically the HMOs are the providers and administrators. You must use the company physicians and hospitals, sometimes with a few well-defined exceptions. Health care required outside of the company providers may not be covered by the insurance, however, emergency care if you are traveling outside the area often is covered. An example of an HMO is Kaiser Permanente

PPO – Preferred Provider Organizations typically act as the intermediary between health care providers and the insured. PPOs are often run by insurance companies. In some cases, multiple hospitals and physicians group together to offer a PPO. Usually PPOs are a little (or even a lot) more expensive, depending not only on what is covered but also on how much choice you are given among physicians and hospitals.

Disability Insurance covers a part of your wages, should you become unable to work. Disability insurance is typically provided through an employer. Individual policies are difficult to obtain. Policies typically provide benefits ranging from 60% to 70% of the insured’s gross income. The definition of what constitutes a disability determines the strength or weakness of a policy, and the cost.

Long Term Care Insurance provides coverage for costs incurred for long-term care centers, in-home care, and part-time care. It is not restricted to older people, but may also cover younger people who become unable to fully care for themselves.

Your Stuff:

Home Owners Insurance is divided into two major sections. The first section covers the home and is broken into four distinct categories:

1. The Dwelling – insures the structure of the home.

2. Other Structures – insures detached structures such as garages.

3. Contents - insures personal property that is owned by the insured (even if the property was not located in the house at the time of loss).

4. Loss of Use – covers some of the cost if your home is so damaged you cannot live there during repairs. Typically the insurance will cover temporary living quarters.

The second section of home owners insurance covers personal liability. If someone sues you because they were injured or their property was damaged in your home this insurance covers your costs, up to a certain limit.

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Apartment or Renters Insurance is like homeowners insurance, but for people who do not own their homes. It covers contents and personal liability. Many apartment complexes now require that tenants have renters insurance policies.

Car insurance is divided into four general areas of coverage:

1. Liability Coverage –for vehicle damage or personal injury to another driver.

2. Medical Payments Coverage –for medical expenses due to an auto accident.

3. Uninsured Motorist Coverage – for your medical and property expenses when the driver of the other car is not insured.

4. Physical damage or loss coverage (“comprehensive coverage”) – for the insured’s vehicle in case of damage or loss of use.

Your Retirement:

Insurance companies bet on both sides of the fence. With life insurance they bet that you will live a long time and pay a lot of money to them in the form of premiums. With annuities they bet that you will live a short time and they will not have to pay you much money in retirement.

An annuity is an insurance contract that, starting at a certain age, makes a cash payment to you for the remainder of your life, regardless of how long you live! Its sole purpose is to insure that you never run out of money during your retirement. However, annuities are very costly, complex, and come in many varieties. Before entering into any annuity-type insurance product, consult with a financial service professional, family law attorney, or certified public accountant (who does not have a vested interest in the selling of the annuity product to you).

What Should You Know About Buying Insurance?Choosing the right insurance agent or broker is important. Due to the complexities of many insurance products it is important to trust your insurance agent. The most important consideration is the financial strength of the insurance company. You want to make sure the insurance company has the financial capability to protect you.

A starting point to determine the strength of the insurance company is to look at the following factors:

a. How long has the insurance company been in business?

b. How large (financial strength) is the insurance company?

c. Review the rating agencies assessment of the insurance company.

a. A.M. Best rating agency

b. Standard & Poor’s rating agency

c. Moody’s rating agency

d. Fitch rating agency

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e. Weiss Research

What Basic Insurance Terms Should You Understand?Actuary - statistician: someone versed in the collection and interpretation of numerical data (especially someone who uses statistics to calculate insurance premiums)Actuarial records – a database used by actuaries.Beneficiary – the person who receives proceeds from a life insurance claim.Claim – the request you submit to an insurance company for reimbursement of your costs.Coinsurance – the insurance company and the insured share the cost of protection. The split is typically predetermined on a percentage basis.Coverage – the areas of protection provided by the insurance policy.Co-payment – a fixed charge for each visit or benefit received from the insurance company. Examples might include: doctor visits, hospital visits, or prescription medications.Deductible – the amount the insured must pay first before any payment from the insurance company.Exclusions – items or areas not covered by the insurance policy.Insurable – able to get insurance coverage Insured property - an assetLiability and/or casualty – insurance for a person who is responsible for damage. If you break someone’s window, you are liable for the damages. If you injure someone with your car you are liable for the casualty. Insured – the person who gets sick or diesMedicare – this is the federal program provided to all retirees who paid into the Medicare system. It is a government sponsored medical care program which has two basic parts: Part A and Part B. Part A is paid by the government for hospital and hospital related costs. Part B is a shared cost by the government and the individual for physicians and other out-of-hospital costs. Important note: Medicare does not cover ALL of your medical needs.Policy – this is the insurance contract. It states the terms of the agreement between you and the insurance company.Premium – this is the payment you make to the insurance company for the insurance coverage.Risk – the possibility of suffering harm or loss.

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