What is the purpose of insurance?
Masters at measuring risk
So how do I evaluate a particular type of insurance?
Consider these scenarios
- So in the first example I gave what is the risk of not having home owners insurance? Well worst case my home is destroyed and I have lost tens or hundreds of thousands of dollars. That’s a pretty big risk. I would prefer to transfer that risk to the insurance company.
- Now let’s consider the other end of the spectrum. I buy a new washing machine for $500 and the salesman is pushing an extended warranty. Should I buy that? Well what is the risk? The worst case scenario is the washer completely dies and I have to replace it. If that happens I’ll be out $500. Do I want to lose $500? Of course not. But $500 is also not likely to bankrupt me. And if I have a good emergency fund I can always use some of that money to replace the washer. Essentially, I have self-insured by having an emergency fund.
- Consider health insurance. If I have no health insurance and have a major medical issue like a heart attack I could easily be on the hook for several hundred thousand dollars in medical expenses. That is very likely to bankrupt me as I would have very little hope of ever paying those bills. You need to have health insurance. The risk is too great.
- Now let’s consider something related. Many companies now promote cancer insurance that pays in the event you are diagnosed with cancer. If health insurance is so important, should I not have cancer insurance too? Well, consider the risk. If you already have health insurance then there’s no real need to have cancer insurance too. Your health insurance will pay regardless of whether you have cancer or some other disease. Consider this why do companies offer cancer insurance and not heart disease insurance? Statistically, you are more likely to die of a heart attack. The reason is cancer is scary. Cancer is emotional. Therefore, people will buy cancer insurance out of fear. But if you have good health insurance you are already covered. Cancer insurance does nothing to lower your financial risk and is therefore generally not a good buy.
Something you hope you never need
Insurance is generally not an exciting topic. It is also kind of a unique product. What other thing do you buy that you hope you never use?
But insurance is a critical part of your financial plan. Insurance protects us against the things that would be devastating to us financially. The key to navigating this maze is understanding that insurance is all about risk.
- What does this insurance really cover?
- What is the worst case scenario if this event were to happen?
- Is this something I could self-insure through savings? Or would it be potentially disastrous to my finances, perhaps even forcing me into bankruptcy?
- Do I already have existing coverage that would cover this possibility?
If the worst happened and would only create a temporary setback or you have other insurance that would cover you then you don’t need to buy this insurance. If however you could not easily recover in the event the worst happened, then you need to transfer those kind of risks to your insurance company.
Sadly, too often, people neglect to consider what insurance coverage they need or they fail to review what they have periodically. Then when disaster hits they find themselves in a very sad circumstance. Please don’t make this mistake.