When Does Insurance Make Sense?

When Does Insurance Make Sense?

Insurance can be one of the most confusing areas of finance. Now is a very good time to be asking this question, given the extreme challenges we faced in 2020 — from the pandemic to hurricanes to wildfires.

To me, the lesson from these horrific events is that we always need to be prepared, not just for what we might be able to predict but for the unexpected as well. That’s where insurance comes in — as a protection for when life deals us a blow.

As confusing or expensive as insurance can seem, it’s absolutely critical to have the right kinds — and the right amounts. In fact, not having the proper insurance can be much more expensive (and even calamitous) in the long run. Let’s take a closer look.

Risk and Insurance

Before we get into the different types of insurance policies, it’s interesting to think about the different ways that we can manage risk and how insurance fits in. In general, when it comes to any risk, there are four major approaches you can take. For example, if your risk is getting into a car accident, you could do one (or more) of the following:

  1. Avoid it. This may not always be possible.

Strategy: Avoid driving.

 

  1. Reduce it. Minimize exposure to the risk.

Strategy: Limit driving in bad weather. Follow speed limits. Obey traffic laws.

 

  1. Retain it. Be aware of and accept the risk.

Strategy: Drive.

 

  1. Transfer or share it. Shift the risk.

Strategy: Buy auto insurance. Use public transportation, ride-sharing, taxis, etc.

When you purchase an insurance policy, you’re following strategy No. 4 by shifting risk to an insurance company. You’re managing a risk that’s difficult (or expensive) to avoid, reduce or retain.

Insurance companies in turn manage these risks by pooling them together with lots of people. The economics work for them because there’s a low probability that many people will face the same calamity at the same time. Some never will.

Insurance Helps You Deal With Unlikely But Financially Severe Probabilities

Insurance is designed to help protect you against low-probability, high-impact financial shocks. Think, for example, of how expensive it would be to cover the cost of a lengthy hospital stay completely out of your own pocket. Most people simply can’t save that much in an emergency fund. It’s impractical and not an efficient use of your money.

On the other hand, it generally doesn’t make sense to insure high-probability, low-impact events because the cost outweighs the potential benefit. For example, it’s often more expensive to purchase a warranty than it is to replace a relatively inexpensive appliance.

Different Kinds of Insurance Can Protect You in Different Ways

There are all sorts of different insurance policies to protect you against different kinds of risks. Here are some of the most essential types and how they can fit into your financial plan:

  • Health insurance can help reduce the cost of medical bills if you get sick. We all need this — no matter our age or current health.
  • Life insurance helps protect your family if you die prematurely. It can also be used for business needs or more complex estate planning strategies.
  • Disability insurance helps protect against loss of income due to being unable to work. Most workers, especially those in their peak earning years, should consider this important coverage.
  • Home, auto and renters insurance protect your home, car or rental property against damage or loss — another must. Earthquake and flood policies provide protection against those natural disasters.
  • Umbrella policies and errors and omissions (E&O) policies can protect your assets and future income if you’re in a lawsuit. Whether you need these types of insurance depends on your individual circumstances.
  • Annuities offer certain guarantees (backed by the claims-paying ability and financial strength of the issuing insurance company) that can protect against outliving your income, especially if you live a long time.
  • Long-term care policies cover expenses associated with needing help with basic activities like eating, bathing and dressing, or care in a nursing home. As you reach your 50s and early 60s, this can be a smart purchase.

Buying Insurance

Whenever you buy an insurance policy, it’s essential to do your homework and check out consumer resources. Work with an independent, knowledgeable professional who can explain features of individual policies and who understands your needs. Be aware of fees, commissions and any conflicts of interest.

Avoid the temptation to simply purchase the cheapest policy. It may actually be more costly in the long run if the insurer can’t pay for claims or provides poor service.

And, finally, ask yourself the following as you go:

  • What happens if I don’t have insurance and something bad happens?
  • Are the risks temporary or permanent?
  • Do I have enough in savings to cover the loss?
  • Is it worth it to protect against this type of loss?
  • How easily can I afford the premium?

If Your Life Changes, So Should Your Insurance

Be sure to review your insurance needs once a year or with any major life event like moving, getting married or divorced, or having a baby. Over time, with more savings and fewer debts, you may need less insurance. This can be in the form of lower coverage amounts. Or, you may be able to afford higher deductibles, which can save you money.

Don’t “set it and forget it” when it comes to insurance.

Insurance Sets up the Foundation for Your Financial Future

Last year was a tough one and a powerful lesson on the need to be prepared for just about anything. As we look to what we hope will be a brighter 2021, it’s still smart to protect ourselves with not only an emergency fund but also ample insurance. Be smart and proactive as you do your research. As the years go by, you’ll be glad you did.

Source: Creators.com