What Is Insurance: How Does It Work? (March 2025)

Paying to fix what goes wrong in life can get expensive. Even if you have the financial resources, reroofing your house after a hurricane, repairing your car after an accident or paying for medical care if you fall seriously ill can take its toll on your bank account and emotional well-being.

Fortunately, having the right insurance can safeguard you, your loved ones and your property when unforeseen events occur. Take a closer look at everything you need to know about what insurance is and how it can protect what matters to you most.

What Is Insurance?

Insurance is a contract you enter into with an insurance company to help safeguard you and your family from financial loss from a mishap, sickness, disaster or some other unexpected event. Think of it as a safety net to keep you from falling into financial ruin when life takes a wrong turn.

The contract is most often called an insurance policy, and it lays out who or what may be covered, what the coverage is—or the circumstances that may require a payout by the insurer—how much may be paid and who may receive the payment.

How Does Insurance Work?

Insurance is similar to your emergency fund. It’s a pool of money an insurance company stockpiles from hundreds or thousands of individuals who pay for those times when bad things happen, such as fires, hurricanes, car accidents and serious illnesses.

All the individuals in the pool are known as policyholders. Premiums paid by policyholders and investments by insurance companies help pay for an insurer’s operations and fund the payment of policyholders’ insurance claims.

Consider an example of insurance for your health. If you get sick, you may go to the doctor, get examined and receive a prescription. So how can insurance protect you from financial loss in this situation?

If you have health insurance, the insurer may help pay for the cost of the visit and medicines by reimbursing you or paying your doctor and pharmacy directly. You may have to pay a deductible, which is the amount you pay before your insurer starts to pay.

The annual or monthly fee you pay, known as the premium, in exchange for an insurance company to protect you financially keeps your policy in effect until you stop paying or the insurance company ends your coverage.

Keep in mind that the most recent data shows healthcare spending in the U.S. increased 7.5% from 2022 to 2023, two and half times the rate of inflation. About 550,000 people file for bankruptcy each year because of medical bills, which accounts for 66.5% of all bankruptcy filings. Insurance works to combat these issues.

What Is the Purpose of Insurance?

The purpose of insurance is to safeguard you, your loved ones and your property from financial losses. Unexpected events, such as break-ins, natural disasters, auto accidents or falls, can be expensive to fix or stick you with expenses you didn’t anticipate.

Insurance helps pay to put things back in order or to fill a financial gap, lessening your burden and stress. Additionally, some insurance is required by law or a lender.

For instance, in most states, laws mandate you carry a minimum of liability auto insurance to drive on public roads. Liability insurance can safeguard you by paying for injuries or property damage you might cause in a car accident.

If you have a car loan or a home mortgage, your lender also might require you to buy insurance. In such instances, the insurance protects a lender’s interest in the property.

What Are the Different Types of Insurance?

There are many different types of insurance. Companies can write a policy for insurance for almost anything that might result in a financial loss, including pet insurance, bicycle insurance and wedding insurance.

However, there are four main types of insurance that just about everyone needs:

Health Insurance

This type of insurance can pay for all or some of all of your medical costs, including hospital stays, doctor’s visits, preventive care and medications. You can buy health insurance from an agency, or you may get group health insurance in your company like a majority of insured Americans.

With group health insurance, you pay your monthly premium, while the insurance company pays a percentage of your medical costs. You pay the remaining costs through a deductible, copays or coinsurance.

Auto Insurance

Auto insurance can ease financial losses from an accident or theft. The different types of auto insurance include property damage and bodily injury liability, comprehensive and collision, personal injury protection and uninsured and underinsured insurance.

Homeowners Insurance

With homeowners insurance, you can safeguard your home and your belongings from damage and theft. A homeowners policy typically can cover damage from fire, vandalism, wind, hail and explosions.

It also can provide liability coverage for injuries to others or their property while at your home. If your home becomes inhabitable, some policies may provide for living expenses elsewhere.

Life Insurance

Have you ever wondered, “Which type of insurance policy would someone get to protect others only?” If so, life insurance is your answer. When you pass, an average life insurance payout can pay for your funeral and burial expenses, as well as for living expenses, bills and education for your loved ones.

You can buy term life, whole life, universal life and variable life insurance.