Insurance is probably one of the most misunderstood components in the arsenal of financial products and yet, it is probably the easiest to explain. Insurance contracts are issued to cover accidents. Accidents are sudden and unexpected occurrences that cause a monetary loss. If losses occur gradually, over time, they are generally not covered by insurance contracts.
The principle of insurance is the substitution of a known loss, the payment of the premium, for a possible one of unknown proportions, the actual monetary value of a covered loss. In simpler terms, when an insured pays the insurance company a premium, the premium becomes the known loss, for he/she will never get those sums back when the period of insurance ends if a covered “peril” does not take place. In exchange for the premium, the insurance company promises to pay all possible losses that are covered by the insurance policy during the period of time that the policy is in force. The tenet is simply to safeguard the policy owner from a larger and yet unknown amount of capital loss if a covered peril strikes while the policy is in force.
If we use as an example a liability insurance policy, we find that for a set amount of premium, the “known” loss, the contract of insurance will pay on behalf of the named insured any losses that arise out of those acts he/she commits or fails to commit that cause bodily injury or property damage losses to others, as long as those acts occur while the policy is in force, not a minute before or after.
If we use as an example automobile collision insurance, we find that for a fixed dollar amount of premium, the “certain” loss, the insurance company’s contract promises to pay to the insured for any losses that arise from a collision in which the insured vehicle is involved, after and during the time that the policy remains in force. Generally, to prevent the abuse of negligently banging up a car with impunity to get a new paint job, the insurance company will also place a deductible, which is an additional sum of money that the insured contractually accepts to pay each time after each accident before the insurance company returns the repaired insured vehicle to the insured’s use or declares the vehicle a total loss and pays off its actual cash value.
An automobile insurance policy is made up of multiple lines of coverage. There is not a set type of coverage that all insurance policies cover. Today, we find more often than not that current insurance carriers allow the insureds to pick and choose the types of coverage they want to have. But careful, if we do not pay a premium for a particular line of coverage, the coverage is not in force.
We may decide to purchase only liability and collision coverage for our automobile. If we are involved in an accident where a branch of a tree falls on top of our automobile as we drive along a shady street, we should not expect to get paid for the incident. Falling objects in automobile insurance are covered under Comprehensive coverage and we did not purchase the coverage when we simply requested liability and collision. Often we choose to save money on coverages that later, after a loss, become necessary; and if we decide to reduce our premiums by eliminating the cost of certain coverages, we also decide at that moment to assume those possible losses later, if any of them occurs.
To conclude our discussion today, let’s explain the term “actual cash value.” Actual cash value is basically the depreciated value of an item. It is the cost new of an item less the loss in value over time for being used, the depreciation. If we buy a couch in a store and months later wish to sell it on Craig’s List, we know that we will never get back the purchase price and must settle somewhere between zero value and the cost new.
That differential between the cost new of an item and the money paid by a willing buyer when we are willing sellers of the item is called depreciation. The same thing happens with refrigerators, boats, automobiles, clothing, and anything of monetary value. Unlike affection for people who are nice to us that grows with time, everything else in life loses value as time unfolds, with few exceptions, of course, as Renoir comes to mind; but those items would require different types of insurance contracts or policies. They require “value” stated policies that cover specifically scheduled items of pre-determined value. Usually the coverage is issued after the insurance company receives appraisals issued by reputable dealers in acceptable form for the items and the company issues coverage with few limitations.
It is essential to understand that in general, the purpose of insurance in our country is to indemnify the insured after a covered loss occurs. Coverage is not meant to make any insured better off than before the loss occurred. The policy coverage is there to leave the insured in the exact same financial position he/she enjoyed before the loss. Keep this concept in mind at all times to prevent you from expecting a fire in the kitchen to resolve your credit card balances or your mortgage debt in the process of restoring the kitchen to its previous condition before the loss. A covered fire in the kitchen will simply clean up the place and restore the space to a functioning kitchen and nothing more.
This brings us to the end of our discussion today. Thanks for your time. Let us know if you found this discussions of value. Share with us how we may improve the content of this blog. As always, we encourage your participation and welcome all comments.