The 2 rules for deciding what type of insurance you need

Insurance is a key part of your financial plan, and yet it is something we often neglect. I think there are a couple of reasons for this.

First, insurance is often expensive and it is one of the only things that we buy that we hope we never use.

Second, and maybe even more important, insurance can be very confusing. There are so many different types of insurance. Health insurance, cancer insurance, accidental death insurance, disability, auto insurance, homeowners, renters, whole life vs. universal life vs. term life insurance, mortgage life, credit card protection, even warranties. I could keep on going and fill a whole article just with types of insurance. What insurance do I need? What insurance is a rip off? How do I know? And then even when I choose insurance often there are many different options. So many choices I think many just throw up their hands and give up.

But the problem is there is probably nothing that will land you in bankruptcy quicker than not having the right insurance: A major hospital stay with no health insurance. Your house burns down and you didn’t have the coverage you thought you had. In a moment of distraction you get in a major auto accident, but you don’t have sufficient liability coverage. These are the types of things that can sink you financially, literally creating a hole it may take years to recover from.

So how do you know what type of insurance you need?

1. What is the worst that could happen if you didn’t have the insurance?

The first question to consider is what is the implication of not having the insurance.

Remember the purpose of insurance is to transfer risk to the insurance company for things that you could not handle.

So for example if I am offered an extended warranty on the microwave I just bought what is the worst that could happen if I decline? Well, if my microwave quits working shortly after I bring it home I may be out the $100 or so I paid for it. That doesn’t make me happy. Losing $100 hurts, but on the other hand it will hardly break me. I could financially recover from that set back without too much difficulty. That is a risk I can safely assume so it makes sense to pass on paying for that extended warranty. (Plus these types of risks are really why you have savings and an emergency fund.)

But let’s consider what if I did not have home owner’s insurance and my house were to burn down? Would I be able to replace my house and all its contents? Chances are unless you are a millionaire, losing your home and everything you own would probably destroy you financially for many years. I can’t afford to take that kind of risk. I need to have home owner’s  insurance that will cover me if something catastrophic happens to my house.

By looking at the worst case scenario you can evaluate whether the insurance protects you against a risk that you can’t take or if the implications of the worst happening aren’t that severe.

2. Am I already covered?

The second question to consider is am I insuring against something that I already have covered?

For example, should I buy cancer insurance? The answer is no if I already have good health insurance. My health insurance will cover me if I get cancer. I don’t need to pay extra for cancer insurance because I am already covered.

Or how about accidental death policies? These cover you if you were to die in an accident. But you should already have a good term life insurance policy in place to protect your love ones if something should happen to you. You aren’t extra dead if you die in an accident; you don’t need to pay extra for insurance.

You want to make sure you are covered for risks you can’t handle, but there is no need to pay twice for the same coverage.

Find an insurance agent who is a teacher

Make sure you have an insurance agent who is willing to take the time to explain what you are purchasing. Never buy something that you don’t understand. If you are confused or it isn’t clear, ask questions. And continue to ask questions until you understand. If your agent is unwilling to patiently explain things in a way you can understand then it’s time to find a new agent.

And lastly, never buy insurance just because your agent said so. Understand that not all types of policies are created equal for your agent. Some types of insurance provide them with bigger commissions than other types of policies. If you feel you are being pressured into signing up for a particular type of insurance and your agent can’t give you a clear explanation of why, it may well be because your agent is hoping to earn a nice commission at your expense.

Please note: I reserve the right to delete comments that are offensive or off-topic.