Insurance: What Is Insurance and Why Do You Need It?

Insurance
Richard BarringtonApr 27, 2022
Key Takeaways:
  • Insurance helps reduce your risk of financial catastrophe.
  • Your insurance policy pays money to you or someone else if something bad happens to you.
  • Common types of insurance include health insurance, home insurance and auto insurance.

Insurance is an investment in financial protection. Depending on your situation, you may need to insure your home, your health, your life and your car, or other things. 

Investing to protect those things makes sense, but it can also get expensive. Knowing how insurance works can help you choose the right types of insurance and keep the costs down.

This article will cover those basics by reviewing:

  • Common types of insurance
  • How does insurance work?
  • Mandatory insurance
  • Insurance FAQs

Common Types of Insurance

In the US, we most commonly insure our cars, our homes, our health and our lives. But we might also insure luxury goods, businesses, and even pets. Here’s a quick rundown of the most common policies that we purchase.

Auto insurance

It’s a grim thought, but the fact is that every time you take a car on the road you risk doing damage to your vehicle, yourself and your passengers, other people on the road and the property of others.

In addition, your car can be a tempting target for thieves. 

Given all those risks, having auto insurance seems pretty reasonable. The average cost of auto insurance is a little over $1,000 a year, according to the Insurance Information Institute

However, those costs can vary widely. So can the types of things an auto policy covers. The most basic policies only cover harm to others and their property - not your own vehicle. 

It’s important to be specific about what type of protection you want in a car insurance policy, and then shop for the best deal on that coverage. 

Homeowner’s insurance

With an average U.S. price of $477,900, a home is often a person’s biggest investment. Balanced against the size of that investment, at an average annual cost of under $1,300 homeowner’s insurance can be a reasonable price for protecting its value.

A key to homeowner’s insurance is knowing what types of hazards the policy covers you against. 

An open peril policy covers your property against any type of damage unless it’s specifically excluded in the policy language.

A named peril policy is more limited. It lists the types of damage the policy covers. If your property suffers damage because of something that’s not on the list, it’s not covered.

Examples of perils that may be covered in a homeowner’s policy include fire, storm damage and power surges. 

Renter’s insurance

Renters don’t have nearly as much at stake as homeowners, but they still could suffer losses to their personal property and have liability for accidents that happen within their apartments. 

The Insurance Information Institute found that the average renter’s insurance policy costs less than $200 a year. That works out to under $17 a month - a reasonable amount to budget for if it means protecting your personal property or even being able to get an apartment in the first place.

Health insurance

Healthcare is very expensive, so health insurance may be the only way of affording the coverage you need in some situations.

After all, in case of a serious accident or illness, you may face medical bills at the same time you’re missing paychecks because you can’t work.

Health insurance is often available through employers, and the Affordable Care Act made it more accessible to people who don’t have coverage through work. Just take care when choosing - the policies that offer the cheapest premiums often are very limited in what they cover.

People sometimes make the mistake of thinking they don’t need health insurance when they’re young and healthy. However, even young and healthy people sometimes have accidents and get sick. 

The fact is, you can’t predict the future, and health insurance is cheapest when you’re young and healthy. That makes it a cost-effective way to protect against the unexpected.

Life insurance

Life insurance allows you to provide for those who depend on you financially. You name a beneficiary, and that person will receive a specified amount if you die while the policy is active. 

There are two main types of life insurance. Term life insurance is more affordable when you’re young, but it only applies for a limited number of years. You can get a new policy after the term expires, but the older you get the more expensive it will be.

Unlike term insurance, whole life insurance doesn’t expire. It will pay a benefit whenever you die, as long as you’ve kept paying for the policy. However, whole life insurance is generally much more expensive than term life insurance.

How Does Insurance Work?

The following are the things that generally go into determining how an insurance policy works:

Coverage type

This determines both what’s being insured, and what it’s being protected against. 

For example, with homeowner’s insurance the coverage of the structure itself might differ from the coverage of the personal possessions inside that structure. Or, a car insurance policy might cover damage from a collision, but not loss due to theft.

When considering an insurance policy, be sure to look carefully at both what’s covered and what perils it’s protected from.

Insurance policy term

This is the length of time the policy is in place. It might be very limited – car insurance policies often have to be renewed every six months. On the other hand, term life insurance might be set up to last for several years, and whole life insurance is open-ended.

Policies can generally be renewed at the end of a term, but the cost may go up. Or, if you’ve made too many claims or your payment history is spotty, the insurance company may decide not to cover you any longer.

Coverage limits

When you file an insurance claim, the amount of compensation you receive is subject to the coverage limits in your policy. 

For example, if you have damage to your home that costs $300,000 to repair but your homeowner’s policy has a $250,000 coverage limit, you’d have to cover the remaining $50,000 out of pocket. 

It’s important to make sure that your coverage limits are in line with what it would cost to repair or replace your property. You should also update your coverage limits from time to time, because repair and replacement costs may rise.

Deductibles

A deductible is an amount you have to pay out of pocket before your insurance kicks in. 

For example, if you file an insurance claim for $3,000 in damage to your vehicle and your auto insurance policy has a deductible of $500, you’d have to pay the first $500 out of pocket. The insurance company would then kick in the remaining $2,500.

Deductibles make insurance more efficient by reducing the number of small claims the insurance company has to process. In return they can make the cost of a policy cheaper, though it’s wise to keep some money in an emergency fund in case you have to pay a deductible if your property is damaged or stolen.

Premiums

The premium is the amount you pay for an insurance policy. It’s often billed monthly, though sometimes you can get a discount for paying the full amount upfront.

Premiums are based in part on the extent of your coverage. For example, the higher your coverage limit, the higher your premiums are likely to be. Also, since a low deductible increases the likelihood that the insurance company will have to pay a claim, low deductibles typically mean higher premiums.

Premiums also depend on the risk that there will be an insurance claim. This can be based on things like:

  • Your past behavior, such as a driving record with multiple accidents
  • Where you live, such as when insuring a home in a flood plain
  • how you use the vehicle – for example, using your car to deliver pizzas is riskier than just taking it out for a weekly trip to the supermarket

Mandatory insurance

In some cases, you may choose to have insurance for your own protection. In other cases, you may be required to have it.

Remember that even if you’re required to have insurance, you still have some choices as to the type of policy to get, the extent of coverage and where you buy it. Those choices can save you hundreds when you pay your premiums, and even more if you have to file an insurance claim.

Here are some examples of mandatory insurance:

Auto liability insurance

Every state except one requires that you have at least enough auto insurance to cover liability to others. 

The one exception is New Hampshire, which requires proof that you can be financially responsible for liability to others even if you don’t have insurance. 

Meeting the minimum liability requirement of your state doesn’t mean your vehicle is covered for damage or theft. So, if you want to protect yourself you should look at more than just the minimum insurance requirement.

Homeowner’s insurance for mortgagees

If you have a mortgage, the lender may require you to carry homeowners insurance. After all, the property is collateral on the loan. If there’s a fire, the lender doesn’t want to see their security go up in smoke.

Even if you don’t have a mortgage that requires you to have homeowner’s insurance, it’s important to consider the consequences if your home was seriously damaged. Unless you have liquid assets far in excess of the cost of replacing your home, insuring that home is a wise investment.

Renter’s insurance

Especially in big cities, more and more landlords are requiring their tenants to have renter’s insurance. 

While this may be an unwelcome addition to the cost of rent, at least it can protect you from the cost of having to replace your possessions if they are lost or damaged due to theft or accident.

Frequently Asked Questions
Should I file an auto insurance claim every time something happens to my car, even if it’s just a small parking lot ding?
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As a general rule, you should save your insurance claims for high-cost problems and those that impede the operation of your vehicle. If you have a deductible, filing a small claim may leave you paying more than you get back from the insurance company. Also, file too many claims - even small ones - and you’re likely to see your premiums rise. 

My wife works and has life insurance through her job while I stay home and look after the kids. Since I don’t have an income, would I need life insurance too?
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Life insurance often makes sense for a non-working spouse. Consider the extra costs of looking after the home and kids that your wife would face if you weren’t around. Insurance can be a way of covering the value a non-working spouse provides on the home front. 

I’m a new driver, and I can’t believe how expensive car insurance is. Are there ways I can bring the cost down?
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Youth and inexperience definitely count against new drivers when it comes to car insurance rates. However, there are things you can do to lower your premiums somewhat. Many insurers offer discounts for taking a safe driving course and for paying your premiums upfront instead of monthly. Some also offer telematics-based programs that can adjust your premiums if you don’t drive a lot and/or if you exhibit safe driving behavior. Finally, opting for narrower coverage, setting a lower coverage limit, or accepting a higher deductible can all reduce premiums, though these approaches could cost you more if your vehicle is damaged or stolen.