How insurance works

Every insurance policy, from a $7 a month phone plan add on to a million dollar home policy, runs on three moving parts: the premium you pay, the excess you contribute when something goes wrong, and the claim that turns the promise into money. Understand these three and you can read any policy in the country.

The premium: the price of the promise

Insurers set your premium by estimating how likely you are to cost them money, and how much. They look at the thing being insured, where it lives, how it is used, and your own history. Two people insuring identical cars can pay wildly different premiums, because the insurer is not really pricing the car. It is pricing the risk around the car.

Underneath, every premium is built from a few pieces added together. First is the insurer's honest estimate of the average claim it expects from someone like you, which is the chance you claim multiplied by the likely size of that claim. On top of that sits the cost of running the business, the staff, the systems and the assessors, then a margin for profit and a buffer for the years when claims run higher than expected. So the premium is never plucked from the air. It is the expected cost of your risk, plus the cost of carrying it, and anything that moves your risk moves the first and largest piece.

The excess: your share of every claim

The excess is the amount you pay toward each claim before the insurer pays the rest. If your excess is $800 and the repair costs $5,000, you pay $800 and the insurer pays $4,200. The excess does two jobs. It stops people claiming for trivial amounts, which keeps the pool cheap to run. And it gives you a lever: choose a higher excess and your premium drops, because you are agreeing to carry more of each loss yourself.

That lever cuts both ways. A $1,500 excess makes the premium pleasant and a claim painful. Never pick an excess bigger than your emergency fund could pay tomorrow.

It is worth seeing the lever move with illustrative numbers. Suppose an insurer offers the same cover three ways: a $500 excess for a $1,300 premium, an $800 excess for $1,150, or a $1,500 excess for $980. Lifting the excess from $500 to $1,500 saves $320 a year, because you have quietly agreed to absorb the first $1,000 of any claim yourself, and the insurer prices that in. The trap is treating the saving as free money. If you crash in the first year, the higher excess costs you $1,000 more at the exact moment you are already dealing with a wreck. So the right excess is the largest one your emergency fund could pay without flinching, and not a dollar more, because past that point you are trading a small certain saving for a large uncertain shock.

The claim: turning the promise into money

• Tell the insurer as soon as possible after the event. Most have a 24 hour claims line or an app.
• Provide the evidence: photos, the other driver's details, a police event number if there is one, receipts for what was lost.
• The insurer assesses the claim against the policy: was this event covered, and what is it worth?
• If approved, the insurer repairs, replaces or pays out, and you pay your excess.

Claims are also where honesty gets tested. Exaggerating a claim or hiding facts when you bought the policy can void the whole thing, leaving you with no payout at the exact moment you need one. The pool only works because its members tell the truth.