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The topic of insurance may be an entirely new experience for someone who has never been familiar with the American financial system before. The American insurance market is full of various acronyms, complicated formulas, and legal jargon. But understanding the mechanisms of how insurance works is crucial for your financial security. On a general note, insurance is your safety net. In return for a relatively small but consistent payment today, you prevent yourself from facing a huge expense in the future. Not buying insurance in America can literally cause you a financial catastrophe right away. In this guide, we will review the basics of how insurance operates, terms you should be aware of, and different types of insurance that can protect your life, health, and possessions.
1. The Fundamental Principles of Insurance
Understanding how insurance operates requires looking at its principles as an aspect of risk management rather than considering individual insurance policies. The principle of operation of insurance business is called statistical risk pooling.
Imagine a group of 10,000 drivers. The probability of each of those 10,000 drivers getting involved in a serious car accident in one year is extremely low. Only several people among them will be unfortunate enough to suffer from an accident. Insurance companies collect consistent payments from those 10,000 drivers and form a fund of money. If one of those drivers crashes his car, he receives compensation from that fund.
How do you become a part of that safety net? To become a participant of insurance, you sign a contract with the insurance company. Your payments and benefits from your coverage depend on four essential factors that affect any insurance policy you are going to buy:
Premium: It is the basic price of your insurance policy. A premium is a periodic payment you have to make to your insurance provider in order to maintain your insurance in action. Premiums can be monthly, semi-annual, or annual depending on the type of your insurance. Failure to pay premiums results in policy expiration.
Deductible: This is a fixed dollar amount of your own money you have to pay in case of any loss before receiving any compensation from your insurance company. For example, if you have a deductible of $1,000 on your car insurance and you damage your vehicle for $3,500, you will pay the first $1,000 from your own pocket, and the remaining amount of $2,500 will be covered by the insurance company.
Policy Limit: An insurance policy has a certain finite coverage amount. Every insurance plan includes a policy limit – the maximum dollar amount of money the insurance company will compensate you according to the terms of this specific policy. Any expenses exceeding that limit will be your personal responsibility.
Exclusion: Every insurance policy covers some things but not others. Exclusions are certain conditions, objects, situations, or risks that will not be compensated for by your insurance company in any way. For instance, the standard homeowner’s insurance will cover fire or wind damage but not earthquakes or floods.
2. Health Insurance: The Basics of the American Medical System
Health insurance is the most complicated but definitely the most crucial kind of protection one will need in America. Unlike most developed nations, the United States lack a universal state-run healthcare system. Medical treatment in America is totally privatized, and the costs of it can exceed tens of thousands of dollars. That is why health insurance is absolutely vital for prevention of medical bankruptcy.
Key Terms of Health Insurance You Should Know
Besides the traditional deductible, there are three more cost-sharing terms that are worth knowing when reviewing your health insurance plan:
Copayment (copay): A copayment is a flat fee you have to pay out of pocket for each time you use a particular medical service. For example, your health insurance plan may require a $25 copay to see a primary care physician or a $50 copay to consult a specialist.
Coinsurance: Coinsurance is your percentage share of costs of covered medical services paid after you have exceeded your annual deductible. For instance, if you have 20% coinsurance and the total cost of the procedure is $1,000, you will have to pay 20% of the cost, i.e. $200, while the insurance company will cover the remaining $800.
Out-of-Pocket Maximum: This is a financial saving grace of any health insurance plan. Out-of-pocket maximum is the maximum amount of money you will have to pay for covered medical services in one year. Once you have paid that amount, the insurance company will cover 100% of all expenses in that year.
Your Insurance Network: HMO or PPO?
When selecting a medical plan through your employer or the public marketplace, you will likely face a choice between two types of insurance networks:
HMO (Health Maintenance Organization): HMO plans are primarily concerned about cost-management. Choosing this option implies that you will have to select a primary care physician, who will act as a gatekeeper. HMO plans cover only those services performed by their narrow network of doctors and hospitals. In case you want to see a specialist, you will have to receive a referral from your primary care physician first. Otherwise, no services will be covered.
PPO (Preferred Provider Organization): PPO plans emphasize flexibility. You are not required to choose a primary care physician or get referrals to specialists. PPO plans have a wide network of covered doctors, but you still can freely visit non-participating providers. However, in this case, you will have to pay a higher coinsurance rate. That is why premiums of PPO plans are slightly more expensive than HMO plans.
3. Auto Insurance: Mandatory Safety Net for Every Driver
Auto insurance is obligatory in almost all states of America because driving without it may cause you serious problems. Insurance is mandatory for every owner and driver of a motor vehicle in America because the expenses related to car accidents can be enormous. Besides the costs of property damages, auto accidents may lead to lifelong expenses for medical treatment of the injured.
Components of Car Insurance
When purchasing a car insurance policy, you receive the following elements of coverage:
Liability Coverage (Mandatory)
This is the most basic and crucial component of any auto insurance policy. Liability insurance is mandatory and required by law. It compensates only the expenses caused by your fault in an accident (property damages or injuries of other people). It is expressed in the so-called tri-digits (e.g., 25/50/25). The first digit is the maximum amount of money the insurer will pay for injuries of one person. The second digit is the maximum amount of money per accident, while the third number is the maximum compensation for property damage. Importantly, liability insurance does not cover your expenses.
Physical Damage Coverage (Optional)
In order to protect your investment in a car, you will have to include physical damage coverages into your plan. They are usually mandatory if you finance or lease your car:
Collision Coverage: This kind of coverage pays for your expenses if your car is involved in an accident with another car, guardrail, tree, or experiences a rollover, regardless of whose fault it was.
Comprehensive Coverage: This coverage pays for any physical damage to your car caused by external circumstances (hitting an animal, theft, vandalism, etc.).
4. Property Insurance: Protecting Your Residence
Property insurance is necessary for both renters and homeowners. Its purpose is to protect your personal property and property you have purchased (your house).
Homeowners Insurance
Homeowners insurance is a multifunctional insurance product that covers both your physical home and your finances. First of all, homeowners insurance provides Dwelling Coverage, i.e. coverage of the costs of reconstruction of the physical structure of your home (walls, roofs, floors, and foundation) in case of fire, lightning, storm, or hail.
Secondly, homeowners insurance includes Liability Protection, which is useful when you have visitors in your home that get injured as a result of falling down in your driveway or on your stairs, or because of being bitten by your pet. Liability coverage will help you cover your legal defense and compensation for the injured party.
Renters Insurance
There is a common misconception among tenants that their landlords are fully insured, and their property will be compensated in case of any damage. However, this is not true. Landlords are insured only against damage to the physical structure of the building. For instance, if a pipe bursts in your neighbor’s apartment and floods yours, causing destruction of your furniture, laptop, and clothes, your property will be uninsured unless you have renters insurance.
Renters insurance is one of the cheapest kinds of insurance (costing less than $15 a month). It will cover your personal property in case of fire, burst pipes, or theft. Moreover, it will cover your liability for accidents (slip-and-fall, dog bites, etc.) that happened in your rented property. What is more, renters insurance will pay for temporary accommodation if your place of living becomes uninhabitable due to covered damages.
5. Life Insurance: Financial Safety Net for Your Loved Ones
Life insurance is different from health and property insurances in the sense that it does not protect the insured person. Instead, it ensures the welfare of your dependents in case of your death. If you have children, parents, or a spouse financially dependent on you, having life insurance is vital. When signing a life insurance contract, you select a beneficiary who will receive money in case of your death. When you die, your insurance company will transfer a check called a death benefit to your beneficiary.
Life insurance is a broad concept that involves two main categories for beginners:
Term Life Insurance (Recommended)
Term life insurance is a basic type of insurance that is valid for a definite period of time (10, 20, or 30 years), and pays if you die within this period of time. Being deprived of complicated investment functions, term life insurance is quite cheap, allowing you to purchase extensive coverage at a minimal premium.
Permanent / Whole Life Insurance
Permanent life insurance is valid for your entire life, and covers investments. That is why there is an option of cash value that accumulates gradually. Due to such complicated nature and guarantees of payments during your entire lifetime, permanent life insurance premiums are significantly higher (five to ten times higher than premiums for term insurance).
Summary Checklist: Creating Your Insurance Portfolio
To ensure your financial stability in America, you should follow the beginner prioritization strategy described below:
Get Covered for Health Care Costs: Purchase a health insurance plan offered by your employer’s HR or enroll in one provided by the government via Healthcare.gov during annual open enrollment.
Meet the State’s Driving Requirements: Obtain a car insurance policy exceeding your state’s minimum liabilities.
Protect Your Place of Living: Buy a homeowners insurance policy corresponding to the cost of reconstruction of your house if you are a homeowner. If you are a tenant, purchase an inexpensive renters insurance plan.
Protect Your Income: If you have dependents or shared debts, purchase an inexpensive yet extensive term life insurance policy.