Time Machine - Is it backing up system files, preferences, etc?
Question 1
Yes, all Time Machine backups are full directory structures of your entire disk (minus backup exclusions). Each backup is made up of hardlinks to unchanged files so each backup appears to be a "full" backup from Finder.

Open your Time Machine volume in Finder (may be within a sparsebundle if you backup over the network) and you should see a folder called Backups.backupdb and under that the machine's hostname. Each backup has a folder in the format YYYY-MM-DD-HHMMSS.

System files are under Library and System. All of your user preferences will be under Users/Username/Library.

Question 2

For user data you can just back up the Library folder. For system stuff you can copy /Library (note that this is separate to the Library folder in your home directory), but it might be better to use a product such as SuperDuper! or Carbon Copy Cloner.

However by default Time Machine will be backing up the entire disk so you should be fine. When you reinstall your OS, you'll get a chance to restore the entire system from a Time Machine backup. If you choose not to do this, when you first boot the new OS you get another chance to restore applications and user data.

On a personal note, I use a combination of SuperDuper! (weekly full system backups to a bootable firewire drive) and Time Machine (incremental backups).