Understanding insurance is a foundational part of financial literacy. Whether you’re insuring your home, your car, your health, or your life, insurance helps protect against financial loss caused by unexpected events. In this guide, part of our Financial Literacy Month series, we’ll explain how insurance works, explore different types of insurance policies, and help you make informed decisions for your future.
Insurance is a way to manage risk. You pay a premium—usually monthly or annually—in exchange for financial protection if something goes wrong. The company providing your insurance coverage agrees to pay claims for specific losses or damages listed in your insurance contract.
The basic idea is simple: we can’t eliminate all risks, but we can prepare for them. For example, if your neighborhood has a 25 mph speed limit, that still carries the risk of a traffic accident. Lowering it to 5 mph would reduce the risk, but it would also disrupt daily life. So we accept some risk and use auto insurance to protect ourselves financially in case of an accident.
That trade-off between convenience and risk is at the heart of why insurance exists. You decide what level of risk you can tolerate and what you’re willing to pay to transfer some of that risk to an insurance company.
Insurance helps protect your finances. It covers unexpected losses—like a fire damaging your home, a medical emergency, or a car accident—that could otherwise be financially devastating. When you experience a covered event, you file a claim, and the insurance company pays you or the service provider, depending on the policy terms.
You typically pay far less in premiums than you would for the actual cost of a loss. A car insurance policy might cost $1,200 a year, but if your vehicle is totaled, it could save you tens of thousands of dollars.
This ability to cover major costs at a small price is possible because of risk pooling. Insurance companies collect premiums from a large number of policyholders and use those funds to pay the few who file claims. Most people won’t experience a claim in any given year, which helps keep premiums manageable for everyone.
Risk pooling also works across time. For example, if a natural disaster strikes and affects many people at once, insurance providers spread the financial impact over many years to remain solvent and reliable.
One challenge for insurers is asymmetric information, which means one party in a transaction knows more than the other. If someone buying health insurance knows they have a serious condition, but the insurance provider doesn’t, the risk to the company is much higher than expected.
This imbalance can lead to something called adverse selection, where high-risk individuals are more likely to seek insurance. If too many high-risk people are covered without proper risk assessment, the insurance company can lose money and become unstable.
A common example of adverse selection is found in health insurance. Smokers are at higher risk for many health conditions, so insurers often charge them more. But if a smoker lies on the application, they may be charged the same as a nonsmoker. If many people do this, the insurance provider might face large losses and may have to raise premiums for everyone.
To avoid this, companies use insurance plans with different coverage levels and require applicants to disclose important health information. Some even require medical exams to better understand each person’s individual risk.
Another issue is moral hazard, where people take more risks because they’re insulated from the consequences. A person with full car insurance may drive more recklessly, knowing they won’t bear the full financial burden of an accident.
To address this, insurers often include deductibles. If your insurance policy has a $1,000 deductible, that’s how much you’ll pay out-of-pocket before insurance kicks in. This discourages risky behavior and helps reduce unnecessary claims.
When shopping for insurance coverage, you’ll need to understand terms like deductibles, premiums, and policy limits:
Let’s say you get into an auto accident and have $10,000 in damages. If your deductible is $1,000 and your policy limit is $15,000, the insurer would pay $9,000. If your damages exceeded the limit, you’d be responsible for the excess.
There are several types of risks that insurance can help protect against:
Homeowners insurance is a form of property insurance that protects your house and belongings. It usually includes:
Keep in mind that disasters like floods or earthquakes are not typically covered and may require a separate insurance plan or rider.
For a more in-depth explanation, see A Guide to Homeowners Insurance.
You can also explore ways to save on this essential coverage with 6 Ways to Save on Homeowners Insurance.
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If you rent your home, renter’s insurance covers your personal belongings and includes liability protection. Unlike your landlord’s insurance policy, which only covers the building, this type of coverage helps protect your items from theft, fire, or other covered events.
Renter’s insurance is especially valuable if you live in shared housing or a high-risk area. It’s usually very affordable and can offer peace of mind for a few dollars a month.
Auto insurance is one of the most commonly purchased types of insurance. It protects you, your passengers, and others on the road. Most states require drivers to carry minimum levels of liability insurance, and lenders often require comprehensive and collision coverage for financed vehicles.
Standard auto insurance policies typically include:
Each of these coverage types can come with its own deductibles and limits. It’s important to compare policy details and ensure you have the right level of insurance coverage for your situation.
You can often customize your auto insurance policy with add-ons or riders. For example:
Understanding these options is part of being a savvy consumer. For more foundational money topics, check out our Basics of Banking guide as part of this Financial Literacy Month series.
When you purchase any kind of insurance, you enter into a legal agreement known as an insurance contract. This document outlines:
Reading your insurance contract carefully is critical. Pay close attention to exclusions and conditions—some policies may not cover claims if you fail to meet certain requirements, like locking your doors or maintaining your property.
If you want extra liability protection beyond what your primary policies provide, umbrella insurance is worth considering. It adds a second layer of coverage that kicks in when your base policy is maxed out.
For instance, if your car insurance covers $250,000 in liability, but you’re sued for $1 million after a serious accident, your umbrella policy can pay the remaining $750,000, if it falls within your umbrella limits.
These policies are especially useful for high-net-worth individuals or those with significant assets to protect. You can learn more about combining different forms of financial protection in our Basics of Saving guide.
Health insurance is essential for managing the high cost of medical care. It helps pay for:
Without coverage, these services can be unaffordable. Even a short hospital stay can cost tens of thousands of dollars.
One common type of health insurance is the Health Maintenance Organization (HMO) model. HMOs require members to choose a primary care physician (PCP) and get referrals for specialist visits. This helps control costs and ensure coordinated care.
HMOs often have lower premiums and out-of-pocket costs but less flexibility when choosing doctors or hospitals.
Other common health insurance models include:
Regular health insurance doesn’t cover everything. That’s where supplemental policies come in:
These policies don’t replace health insurance but can ease the financial burden of unexpected medical events.
Disability insurance is designed to protect your income if illness or injury prevents you from working. There are two main types:
In addition, long-term care insurance helps cover services such as:
As outlined in Medicare’s long-term care coverage, Medicare does not typically pay for long-term custodial care, so this type of insurance is especially important for retirees planning for future medical needs. You may also qualify for Social Security disability benefits if a medical condition prevents you from working long term.
It's important to include health-related expenses impact budgeting and savings goals when using tools like our Budgeting Calculator and Savings Goals Calculator.
Health insurance plans don’t always include dental or vision care. Separate insurance plans are often available to cover:
Dental insurance can also cover more extensive procedures like oral surgery or orthodontics, depending on the policy. For families or individuals with ongoing dental or vision needs, these plans can provide valuable support.
One of the most confusing parts of health insurance is co insurance, which is different from a co-pay. With co insurance, you share a percentage of the cost of a service with your insurer after you meet your deductible.
For example, if your co insurance rate is 20%, and your medical bill is $1,000 after you’ve met your deductible, you’d pay $200 and the insurer would pay $800.
Understanding cost-sharing is essential when comparing health plans. Some have higher premiums but lower out-of-pocket costs, while others are more affordable monthly but can result in high costs during medical emergencies.
Life insurance is designed to provide financial protection to your loved ones if you pass away. It’s especially important if you have dependents who rely on your income. The money from a life insurance policy—called the death benefit—can be used to cover funeral expenses, replace lost income, pay off debt, or fund future needs like college tuition.
There are two primary categories: term life and permanent life insurance.
Term life insurance is the most straightforward and affordable type of coverage. You choose a coverage period—such as 10, 20, or 30 years—and if you pass away during that term, your beneficiaries receive the full death benefit.
Term life is ideal for people who want to protect their family while they’re raising kids, paying off a mortgage, or building up savings.
Whole life insurance (sometimes called permanent life insurance) provides coverage for your entire life, not just a set term. These policies also include a cash value component that grows over time.
Types of permanent insurance include:
The cash value in permanent policies can sometimes be borrowed against or used to pay premiums, but borrowing may reduce the eventual death benefit.
You may wonder whether life insurance is necessary for people without income, such as children or retirees.
For children, a small insurance plan may be purchased to cover final expenses or lock in insurability in case they develop a health condition later. However, most families don’t need large life insurance policies for kids.
For retirees, the goal is often to cover burial expenses or provide a small inheritance. If you’re no longer earning an income that others depend on, a full policy may not be necessary; though it can be helpful for estate planning or tax purposes in certain cases.
When a claim is filed, insurance companies usually process the payment within 30 to 60 days. However, certain events can delay or void a payout:
If approved, the payout may be a lump sum or installment payments over time. Structured payments can help beneficiaries better manage large sums of money.
In some cases, pre-death benefits (also called accelerated death benefits) are available. If a policyholder is diagnosed with a terminal illness, they may receive a portion of the death benefit early to help with medical or living costs.
For high-net-worth individuals, life insurance can be used as part of a larger estate plan. In many cases, life insurance benefits are not subject to estate taxes, which allows heirs to receive the full amount tax-free. This makes permanent policies a popular option for preserving wealth across generations.
Beyond health, auto, and life, there are many specialized types of insurance plans designed for unique situations.
If you’re planning a trip—especially internationally—travel insurance can be a smart investment. It may cover:
Some policies also include emergency evacuation or repatriation services. Your primary health insurance may not cover care in other countries, making travel insurance a valuable safety net.
Pet insurance helps cover the cost of veterinary care, including:
Some plans also include wellness coverage for vaccinations and routine care. With veterinary costs rising, pet insurance is becoming more popular among pet owners.
Credit insurance is offered by credit card companies or lenders. It pays your minimum monthly payments if you’re unable to work due to illness, injury, or job loss.
However, we generally advise against purchasing this type of insurance. The premiums are often high for the limited benefits provided. Instead, consider focusing on debt reduction strategies and building an emergency fund.
Private mortgage insurance (PMI) is a related product. It’s often required by lenders when homebuyers put down less than 20% on a mortgage. PMI protects the lender—not the borrower—if the homeowner defaults. To avoid PMI, consider increasing your down payment or refinancing once you reach 20% equity.
ID theft insurance promises to cover the costs associated with recovering from identity fraud. This might include:
However, ID theft usually doesn’t involve direct financial losses for the victim; banks and credit card issuers often reimburse fraudulent charges. The bigger cost is usually time and stress, which are hard to insure. If you’re concerned about ID theft, you may be better served by proactive credit monitoring and fraud alerts.
When you rent a vehicle, you’ll often be offered rental car insurance at the counter. But do you really need it?
In many cases, no. If you already have a personal auto insurance policy with comprehensive and collision coverage, it likely extends to rental cars in the U.S. Additionally, many credit cards offer secondary or even primary rental insurance if you use the card to pay for the rental.
Still, rental car insurance may be useful if:
Before declining the coverage, check with your insurance company and credit card provider to verify what’s included.
Workers’ compensation insurance is required in most states and provides protection for employees who are injured on the job. It typically covers:
Workers’ comp is paid for by the employer. If you’re a small business owner, you may need to obtain coverage to comply with state law. If you’re an employee, understanding your rights can help ensure you’re protected in the event of a workplace injury.
One of the most important aspects of insurance is the way it supports your financial stability. An unexpected emergency—like a hospital stay, car accident, or home disaster—can wipe out savings or push you into debt.
With the right insurance coverage, you can:
Insurance is not just about paying premiums; it’s about having a financial safety net so your goals aren’t derailed by the unexpected.
If you’re working toward financial goals, you may also benefit from tools like our Savings Goals Calculator, which helps you plan ahead for future expenses.
Choosing the right insurance plan depends on your age, family situation, health, income, and financial goals. Ask yourself:
As your life changes, so should your insurance. Getting married, having children, buying a home, or retiring are all good times to review your policies.
When shopping for insurance, consider these strategies:
And remember: price isn’t everything. The cheapest policy may leave you exposed to major losses if it doesn’t cover enough.
Insurance companies are regulated at the state level. Each state has its own department of insurance that monitors:
If you have a complaint or suspect fraud, you can contact your state insurance department for help. The National Association of Insurance Commissioners (NAIC) website provides state-by-state resources.
You can also turn to trusted educational sources like the Insurance Information Institute for unbiased, up-to-date content about insurance products and companies.
Disasters like floods, earthquakes, hurricanes, and wildfires are becoming more common. Unfortunately, many standard homeowners insurance policies don’t cover these events.
To protect against these fundamental risks, you may need:
If you live in an area with high disaster risk, consider adding these coverages to your property insurance plan. For disaster recovery tips, read Dealing with Debt After a Natural Disaster.
Understanding how insurance works is a major part of becoming financially literate. That’s why we’ve included this topic in our Financial Literacy Month series.
If you’re working to improve your financial knowledge, we also recommend these resources:
From budgeting to saving, understanding how each piece fits together—including insurance—will help you make better long-term financial decisions.
To wrap up this section, let’s debunk a few persistent insurance myths:
Being able to separate fact from fiction is key when making informed insurance decisions.
Your personal finances aren’t just about earning and saving; they’re also about protecting what you’ve built. Without insurance, a single major expense could undo years of careful budgeting or set you back financially for decades.
That’s why insurance is such a crucial part of any solid financial plan. It works hand-in-hand with emergency savings, retirement funds, and investments to give you peace of mind and long-term security.
If you’re just starting to build your financial foundation, visit our article on the Basics of Saving to learn how to grow a safety net before disaster strikes.
For wealthier households, insurance isn’t just a protective tool; it’s a way to preserve and pass on wealth. High-value life insurance policies can be structured to avoid estate taxes. Long-term care policies help protect retirement assets from being drained by medical expenses. And umbrella policies ensure that one lawsuit won’t upend a lifetime of savings.
If your financial situation is more complex, consult with a qualified insurance advisor or financial planner. Credit.org does not offer legal or tax advice, but we can help you better understand the tools available to protect your finances.
Your insurance needs aren’t fixed; they change over time. Make it a habit to review your policies annually or whenever you:
Set reminders to review coverage limits, beneficiaries, deductibles, and policy riders. Update outdated contact information or employment details with your insurance company. Don’t let an oversight put your coverage at risk.
When dealing with an insurance company, communication is key. Here are some best practices:
Look for insurers with strong reputations, high financial strength ratings, and transparent claims processes. Use resources like the Insurance Information Institute or or USA.gov’s insurance resource center for a broad overview of federal insurance programs and consumer protection.
If you experience a covered event, follow these steps to file a claim efficiently:
Being organized and prompt can make a big difference in how quickly and fully your claim is paid.
Unfortunately, insurance fraud is real. Watch out for:
Always verify the licensing of agents or brokers. Don’t provide payment information unless you’ve reviewed all terms and are confident in the provider. If something feels off, walk away and get a second opinion.
For another way to think about avoiding fraud, see our article on Basics of Incentives, which gives some insight on how to evaluate offers and protect yourself as a consumer.
Insurance isn’t just about preparing for the worst; it’s about giving yourself freedom and peace of mind. With the right insurance coverage in place, you can make big life decisions—like buying a home, starting a family, or launching a business—without fear that one misstep will wipe out your financial progress.
As part of our ongoing efforts to support financial literacy, we encourage you to take the time to review your current insurance situation. Whether you’re just getting started or reevaluating after a major life change, having the right coverage makes a difference.
If you’re unsure about what you need, we’re here to help. Credit.org offers free financial counseling that can help you evaluate your insurance-related questions in the context of your broader budget and debt situation.
We also provide disaster relief counseling for those needing help with recovering from worst-case scenarios. .
