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Talking about Insurance is Boring! (but Necessary)
In the Personal Finance Basics series I’ve (very slowly) been working through, it is now time to talk about insurance. So, what is insurance? (it’s boring! – well, ok, that might be true, but that’s not what I mean here). I mean, what is the definition of insurance? Actually, I don’t mean that either. I mean what does insurance accomplish? I think it makes sense to think of it as a transference of risk.
Insurance is a transference of risk
In exchange for a small amount of money, the insurance company will give you a large amount of money in the rare case that you need it. You are therefore transferring the risk of having to pay a large amount of money to the insurance company. I think this definition works well for most types of insurance, but not perfectly. For instance, it does not apply strictly to most health insurance plans in the US since we want our insurance to cover all office visits and procedures, not just the very expensive and rare ones (though it does do that also)
Do I really need insurance?
Determining whether or not you need a certain type of insurance is a very important first step. Each person’s individual circumstances will determine which types of insurance are necessary. You should discuss this with a qualified professional and/or a trusted person (or persons) who can give you good counsel.
The least expensive (at least in the short-term) form of insurance is always self-insurance (I mean no insurance). Of course, if you end up needing the insurance payment, then self-insurance becomes significantly more expensive. But if you can afford the payment if the risk is realized, then you don’t need to purchase insurance. For instance, if you have the money to rebuild your house (and replace everything in it) if it burns down, you don’t need homeowner’s insurance. If you can afford to lose a lawsuit, you don’t need an umbrella policy. If your family can afford to continue their current standard of living if you die, then you don’t need life insurance. If you can’t afford any of these, however, then insurance is a good idea (a very good idea)
Again, each person has reasons for whether or not they need a certain type of insurance – there is no one size fits all answer to this question. I’m listing some common insurances that you should consider – it doesn’t mean you should buy them all (I don’t currently own all these types) nor does it mean there aren’t more that you should consider.
Common types of insurance
- Health – At the very least, you should have a major medical policy that will pay for expenses like surgeries or serious illnesses that can quickly generate enormous bills for you. Even if you have to pay for office visits ($) out of pocket, the risk of a huge hospital bill ($$$$$) is too much to ignore.
- Home Owner’s or Renter’s – These policies pay for rebuilding or repairing your house and/or your personal belongings in case of a disaster such as a fire or robbery. Having such a policy is a very good idea for almost everyone (and most mortgage companies will require one). Just note that some disasters, such as floods or earthquakes, are not typically covered under home owner’s policies. Also, look for a policy that provides "replacement cost" for your items.
- Auto – Auto insurance is mandatory in most places in the US, I believe. Even if it was not, it is still a good idea for everyone who drives. Not only do most policies provide payments to cover damage to your car and other cars in an accident, they also cover liability issues that may result.
- Personal Liability (Umbrella Policy) – If you want to ensure you are very well protected, purchase a personal liability policy. This policy acts like an "umbrella" to cover your liability over and above that which is provided by your auto and home owner’s insurance. As Dave Ramsey says, the best way to protect your assets in the case of a liability suit is to put a big, fat, ugly insurance company between you and the other party.
- Disability Insurance – The greatest asset that most people will have in their lifetime is their ability to earn an income. Disability insurance is what protects this asset. If you are unable to work, disability income will replace some or most of your income. There are two flavors, short and long term. Long-term is extremely important if you were to suffer some sort of debilitating injury or illness and not be able to work for years. The best (and most expensive) type is "own occupation" insurance. It means the insurance company will pay-out as long as you are unable to work in your current occupation. In other words, if you have a professional job, they are not going to force you to get a job at McDonald’s and stop paying you benefits. On the other hand, if your job entails sitting in an office in front of a computer (like mine does), if you can’t do that there’s a pretty small chance there would be some other kind of job they could make you do.
- Long-term care – Long-term care insurance pays for care in the event that you can no longer care for yourself. Due to the enormous (and ever-rising) costs of long-term care (in a competent facility), LTC is probably a good idea for most people. Though inexpensive for young people, the recommendations I’ve seen are to wait until between the ages of 50-60 to get a policy. There are a lot of options and policy types for long-term care – too many to go into any detail in this post.
- Life – Life insurance is very necessary for some people and quite unnecessary for others. If you are single and have enough money for a proper funeral, you don’t have much need for life insurance. Likewise, if you are married with no (or grown) children and a large enough net-worth for your spouse to continue his/her current lifestyle, again you don’t have much need for life insurance. On the other hand, if you are the sole breadwinner of a family with a few small kids, your needs are enormous. I’ve heard that the general rule of thumb for life insurance is seven times your annual salary – but personally, I think that the actual need varies greatly by your specific situation. There are numerous life insurance needs calculators you can find online. If you need life insurance, my advice to you would be to get a 20 or 30-year term-policy and get a lot of coverage (term policies are very inexpensive, so load up on the coverage).
Of course, there are many other types of insurance out there (but I’m already over 1100 words on this post) but I feel these are the most common that are needed by most people. Would you suggest any other types for most people to consider?
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4 Responses to “Talking about Insurance is Boring! (but Necessary)”
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It’s funny, as I get older, I find myself thinking a lot more about this sort of thing and how nice it would be to have all different kinds of great insurance policies. Carefree living right? The first thing I would do with disability insurance though is to commit fraud, so I’ll stay away from that one.
Insurance is one those subjects that can be less than exciting to talk about. As mundane as it might be though, understanding insurance is incredibly important for properly evaluating how to best protect yourself and your family from the unknown. As you point out, insurance is about transference of risk and whether a person wishes to accept risks associated with certain situations and properties.
Gaining a proper understanding of insurance, however, can be challenging. It can be such a complex topic that it can often seem too overwhelming to grasp. As you recommend, if you have someone you trust who fully understands the ins and outs of insurance, he or she can be very useful in helping you evaluate your situation.
As a representative from State Farm, I can tell you that we have found there are certain moments throughout a person’s life, such as having a baby, buying a car or home, or moving, when insurance needs are most often thought about. The State Farm website includes a learning center to help when those “life moments” happen: http://www.statefarm.com/learning/learning.asp.
I hope you find this helpful.
I really don’t believe that we need most of the insurances offered to us. Many times they are simply a gimmick aimed at generating revenue for greddy financial orgainsations and whilst they can offer some benefit to a small few, the vast majority get ripped off. The only insurances that i think are useful are Life Insurance, because it’s important to make sure your family are provided for and critical illness which covers your mortgage in the event of you suffering a critical illness.
Jonathan@Friends&Money´s latest blog post…How To Talk About Debt Problems With Family Members
@Jonathan – I’m a big fan of life insurance when you need it. Like if you are married with young kids and a mortgage, you probably need a pretty large policy. If you’re retired, kids are on their own, and you’re wealthy from years of fiscal prudence, then I’m not sure you really need any. I am not familiar with critical illness insurance to cover your mortgage – is that like disability insurance here in the US where if you are can’t work for an extended period of time they pay you money so you can afford you bills and expenses?