Insurance Basics

About 8 minutes
 
So you’re saving money, have your debts under control, and are investing like a champ. Nothing left to do, right? Well, not quite. Now it’s time to talk about insurance.
 

What is insurance?

As you probably know, insurance protects us from accidental losses.
 
But wait, isn’t that what an emergency fund is for?
 
Not exactly. Emergency funds are there in case you lose your job or need to cover fairly minor expenses that show up unexpectedly. Insurance, on the other hand, is primarily there to protect you from the really big losses that would be disastrous to your finances, like losing your home to a fire, a major medical expense, or the loss of a loved one who supports others financially.
 
Sad things happen unfortunately, so it’s important to make sure you and your family are protected ahead of time.
 

How insurance works

For you as a consumer, most insurance works in a similar way. You make periodic payments up front, called premiums, and then if an insurable event occurs (i.e. something bad/expensive that’s covered by your insurance), you’ll be protected. Small payments now for big protection later.
 
Insurance providers are able to do this by pooling, or spreading, the risk across many customers. By selling insurance to thousands of people, the provider can be fairly confident that only a certain percentage of claims will be filed at any given time. So they can then estimate how much money they’ll need to be paying out and charge premiums accordingly.
 

Okay, so what types of insurance should I know about?

Well, there are actually quite a few types of insurance out there. But for most of us, insurable risks fall under two main categories;
 
1) Risk to our physical bodies (health insurance, life insurance, disability insurance)
 
2) Risk to our property (auto insurance, renter’s insurance, homeowner’s insurance)
 
We’ll do a quick overview of each type, starting with health insurance.

 

Health Insurance

As you probably know, health insurance helps cover medical costs, like a routine check-up, a trip to the emergency room, and a lot more. We’ll save the details for the next section which is actually dedicated to health insurance.
 

Life Insurance

As the name indicates, life insurance is used to insure against the loss of someone’s life. So if someone relies on you, whether you’re the primary earner or a stay-at-home parent, it’s a good idea to have life insurance in case you die unexpectedly. We also have a separate section on life insurance so we’ll spare the details here.
 

Disability Insurance

Disability insurance is designed to protect you in the event you can no longer work and earn a living. Most of us never think we’ll become too disabled to work. But unfortunately, more than one out of four twenty-year-olds can expect to miss at least a year of work before they reach retirement due to a disability.
 
And while the government does offer some protection with Social Security Disability Insurance (SSDI), the payments aren’t guaranteed, can take a long time to process, and may not be enough to cover all of your needs.
 
Long story short, it can be a good idea to buy private disability insurance, depending on your situation. Your employer may even offer it, so check to see if they do. And if you want to learn more about getting disability insurance, we have you covered.
 

Auto Insurance

Auto insurance isn’t for the inevitable minor dings and scratches, it’s for major repairs and accidents. In fact, auto insurance serves two purposes;
 
• To protect you against collision
 
• To protect you against liability
 
Collision insurance is about protecting the value of your car, helping you to repair or replace it if it gets damaged. Unfortunately though, if your car gets totaled and you do need to replace it, your insurance likely won’t cover the entire cost. Instead, the amount will be based on the book value of your car, which decreases with time. In fact, if your car is older, it may not even be worth having collision coverage at all.
 
Liability insurance is a different story. That’s about protecting your finances in case you’re in an accident and get sued. Without it, you could potentially end up on the hook for a lot of money.
 
While most states require you to have auto insurance, the minimum requirement may not offer enough protection, especially if you’ve built up some savings or own your home. Keep in mind, this is to protect you from a really bad situation.
 
So how much liability coverage should you have?
 
One rule of thumb is to have at least twice your net worth covered. Liability is not something you want to skimp on. And if you have a high net worth, you may also need to get an additional umbrella insurance policy that goes beyond the liability coverage limit.

 

Renter’s Insurance

If you rent your home, it’s a good idea to have renter’s insurance. It’s intended to cover your possessions from theft or damage (like in a fire) and also protect you from personal liability. For example, if someone is in your home, gets injured, and decides to sue you.
 
With renter’s insurance, you can choose between covering the actual cash value (ACV) of your possessions and the replacement cost value (RCV). Actual cash value refers to what your stuff is actually worth. Replacement cost value refers to what it would cost you to replace it.
 
But since you don’t need to actually cover the value of the home itself, renter’s insurance is generally much less expensive than homeowner’s insurance. Which brings us to…
 

Homeowner’s Insurance

If you own your home, it probably represents a huge portion of your wealth, so you need to protect it. And homeowner’s insurance is designed to do just that. (Also, if you’re like most homeowner’s and have a mortgage, your lender will probably require you to at least have enough homeowner’s insurance to cover the amount of the loan.)
 
Plans vary in terms of what types of insurable events they cover. So you need to be specific when you’re choosing coverage. Be sure you know exactly what’s covered and how those events are defined. You don’t want to find out after the fact that you weren’t actually covered for something you thought was covered.
 
For the most part, you should plan on covering smaller, more frequent expenses with your emergency fund. And then rely on insurance for major events, like a fire. Since these types of events tend to occur infrequently, you may be better off choosing a higher deductible plan with lower premiums.
 

Understanding the insurance lingo

A lot of terminology is thrown around in the world of insurance, so it can get a little confusing. We already discussed premiums – the periodic upfront payments you make in exchange for insurance coverage. But there are some other important terms to be aware of if you aren’t already.
 

Deductible

The deductible is the amount of money you’re on the hook at pay before your insurance kicks in (i.e. your insurance doesn’t cover the entire amount).
 
Insurance policies vary by the size of the deductible. And usually there’s a trade-off between how much you have to pay in premiums and your deductible. The lower the premiums, the higher the deductible, and vice versa.
 
So while some policies may look more attractive because they charge lower premiums, you could be stuck making a higher deductible payment later. Whether you’re shopping for health insurance, auto insurance, homeowner’s insurance, whatever, you’ll want to make sure you have enough money in your emergency savings to cover your deductible payments.
 

Coinsurance

With coinsurance, you share a portion of the cost with your insurance provider, often with a tiered structure and a maximum amount you’ll be on the hook for, called the out-of-pocket limit or coinsurance limit.
 
A fairly common split is 80/20, meaning you’ll cover 20% of the cost and your insurance will cover 80%, up to the out-of-pocket limit, after which point your insurance will cover the rest.
 
While coinsurance can technically apply to various kinds of insurance, it’s usually associated with health insurance, which we’ll see again in next section.
 

Coverage limit

Some types of insurance have a coverage limit, which is the maximum amount the insurance provider will pay out for an event. As we’ve already mentioned, if a particular insurance policy does not offer as much coverage as you need, you can extend it with an additional umbrella policy.
 
Anyway, these are just a few of the important insurance terms you’ll want to know, and if you need to look up more, you can find them on the National Association of Insurance Commissioners (NAIC) website.
 

What is underwriting?

When you buy insurance, your provider will want to understand how “risky” you are, or how likely you are to have an insurable event. This will determine how much they can expect to pay out in the future and, as a result, will likely impact the cost of your insurance premiums, depending on the type of insurance.
 
This process is called underwriting.
 
Similar to lenders assessing your credit risk, insurance underwriters assess insurable risks, factoring in your specific information, like;
 
• Your health and life expectancy for life insurance
 
• Your driving history for auto insurance
 
• Where you live for homeowner’s insurance
 
The riskier they think you are, the more you’ll end up paying in insurance premiums.
 

Side Note: Health insurance underwriting works a little differently because insurance providers can not legally charge different premiums based on your medical history, but they can charge more based on your age and if you use tobacco.

 

Finding the right policy

When you’re looking for insurance, don’t be afraid to shop around and compare offers. We know it’s not too exciting, but you’ll want to make insurance providers compete for your business. Talk to a few and see who can offer the best deal.
 
And when you do buy insurance, you’ll get a copy of your policy, the legal contract that explains the terms and conditions of your coverage. It will spell out all the little details, like what events are covered and how much you’ll be on the hook for with the deductible and coinsurance.
 
Be sure to actually read your policy when you get it.
 
Yes, it may look a little intimidating/boring, but you’ll need to know if it actually covers what you need it to. And be sure to straighten out any issues or questions you have in advance of needing your insurance.
 
 

Key Take-Aways

1) Insurance is there to protect you against large losses, not relatively minor expenses that can be covered with an emergency fund.

2) Insurance can be used to cover risks to yourself (health, life, disability) and to your property (auto, renter’s, home).

3) In general, there’s a financial trade-off between deductibles and premiums – lower premiums usually means a higher deductible. Think about how much you’ll be paying.

4) Insurance providers use underwriting to assess your insurable risk and factor that into the cost of your insurance. Be sure to read and understand your policy.

5) Don’t be afraid to shop around and make insurance providers compete for your business.

 

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