Here’s an Easy Way To Think About Insurance

Posted by: Joseph Kuo | July 7, 2022

Insurance is a topic that most people tend to avoid and may even find intimidating or scary. However, in modern life, it is an important part of any financial plan to protect yourself and your family.

Over time, certain types of insurance policies have gained a bad reputation because of their complexity or because brokers and advisors either haven’t sufficiently helped consumers understand the policy or had a vested interest in selling the policy.

Risk Categories

Almost all types of insurance policies exist for a reason; to protect themselves or a loved one from a significant loss. When thinking about insurance, it’s worthwhile to start with why insurance policies exist in the first place.

In general, we can divide risk into four general categories:

Low Probability, Low Impact

We don’t need to worry about these things. If the loss happens, the impact on our lives would be negligible and we can easily replace the loss. Examples include losing a mundane item such as a pen.

High Probability, Low Impact

These events will generally happen over time, but there are preventative measures we can take to mitigate or delay these losses. Regularly checking our tire pressure over the long run will save on tire replacement costs.  Fixing the leaks in the roof will save us from having to eventually replace the roof entirely.

High Probability, High Impact

Hazardous events such as race car driving or hang gliding are generally not covered by insurance because they carry a very high risk of death or disability. There’s not much we can do to mitigate risk here other than to avoid these sorts of activities.

Low Probability, High Impact

These things thankfully don’t happen often, but if they did, the loss would be catastrophic. Losing your home in an earthquake. An illness or disability that keeps you out of work for several months. Your spouse passing away.

These types of events are where insurance policies come in. Because the impact of the loss would be so high, we want to do something to protect ourselves against it. However, since the financial cost of replacing the loss would be so great, for these types of events we would instead just buy an insurance policy.

Some people also use insurance policies to help with tax and estate planning, but that type of protection is best carried out through a detailed financial plan created by a financial advisor.

Should I Buy A Policy?

When deciding whether an insurance policy is worthwhile, ask yourself these questions:

Is It Worth The Premium?

With this approach you’re weighing the cost of the premium versus the likelihood of a claim and the amount of coverage. Depending on your comfort level with math, you can do anything from simple “napkin math” to a full statistical analysis using actuarial tables.

Even though this method is the most objective way to consider the value of an insurance policy, there will still be some subjectivity in the approach. While you will know the cost of the premium and can reasonably estimate how much a claim would be, the probability of loss is still generally a subjective assessment. Even when referring to tables that track statistical averages, you would need to decide how you compare to the average.

Will It Cover Something I Can’t Replace On My Own?

There are a few things in life that would be difficult or impossible to replace. Some examples include our home, or our future income from now until we retire. We can’t afford to save up enough money to replace these things, so here’s where we would need to buy a policy with enough coverage to cover the replacement cost.

Arguably, anything that we can afford to replace immediately does not need to be insured. Most things we buy have reasonably good quality these days and chances are that these products will work beyond their anticipated service life. Practically, this means policies such as mobile phone replacement insurance or extended warranties on our laptops would cost us more in premiums than what they would return in claims. So, it’s not worthwhile to insure the small things.

In cases where we don’t know how much to insure, such as liability coverage for when we contributed toward someone else’s loss or injury, there are frequently required obligations that we must satisfy. In auto and homeowner’s insurance policies, there may be minimum levels of  liability coverage we must take. For example, Personal Umbrella Liability Policies (PULPs) typically require a minimum amount of home/auto coverage.

For people with more assets, it is worthwhile having sufficient liability coverage to replace most of their net worth. Again, the goal is to cover what we cannot afford to replace.

Will It Give Me Peace of Mind?

This is the most subjective way to consider insurance policies. However, perhaps it is also the most important one. After all, if one goal of financial planning is to give us greater peace of mind and security for the future, we should take care of the things that would keep us up at night.

This doesn’t necessarily mean that you should buy every insurance policy for every possible risk that you can think of. This does mean that, in considering risk management and insurance policies, you should think about what matters most to you and the things you most want to preserve and protect. You should also keep in mind that what’s most critical could change over time.

For example, during your working career while raising a family, it would be important to insure your future income in the form of life insurance and disability insurance policies. However, once your kids are out on their own, you’ve accumulated sufficient assets, and are close to retirement, you’d no longer need to insure for future income.

Another example is that if your family has a history of longevity but long-term health issues, you might consider purchasing a long-term care policy with high benefits. On the other hand, if you have a family history with many acute illnesses, a lower benefit long-term care policy and getting health insurance with a lower annual deductible might be a better fit.

Once you answer these three questions, you should have a good general idea of whether the policy is right for you. To get the ultimate peace of mind, an experienced financial advisor can walk you through the decision process and make sure you have the right types and the right amount of coverage for your financial situation.