Insurance PolicyFinancial Dictionary -> General Finance -> Insurance Policy
Insurance is a way of hedging potential loss by monetizing a potential risk. Using life insurance as an example the policy holder is hedging the loss from the risk of death. A family man that is the only person in the household that works would probably leave his family with monetary issues if he passes away. If he has life insurance, a payout would be made to the family, giving them time to mourn and then sort out any lack of income.
The process of insurance usually works on the monthly payment system. The policy holder will pay an amount in to the policy each month. The contract will outline what requirements need to be met for a payout. For example death, unemployment, property damage (depending on the individual policy). If these requirements are met the insurer will make a payout to cover the loss. The idea is that paying a small amount each month is less than the potential loss incurred if the actual requirements of the policy are met. Of course payout may never be reached, but that is part of the hedging process.
The insurer is banking on the fact that only a percentage of policy holders ever need a payout, thus they will make a profit from all of their monthly payments. On top of this they will invest payments to make more returns for the company.
The insurance companies will individually asses each case for risk of a payout. The higher the potential for a payout, the higher the monthly payments will be. For example somebody with a life threatening illness is unlikely to be given life insurance, unless payments are extremely high.
Insurance companies are often criticized for monetizing fear.