How Insurance Works by Emily Murphy, CFP®Submitted by Moller Financial Services on November 20th, 2019
How Insurance Works by Emily Murphy, CFP®
Insurance works by paying an insurer a premium in exchange for the promise that your loss be made whole if it occurs. The bigger the group of premium payers, the more predictable the chance of loss. Insurers can predict with amazing accuracy the long-term results for the averages of some random event occurring in a large population. However, not all events make economic sense to insure. Some are too likely or too catastrophic that the premiums are unaffordable. Conversely, some events are too unlikely or not catastrophic enough to warrant paying a premium.
Therefore, those are two characteristics you should evaluate before buying insurance:
- What is the frequency? How likely is this bad event to happen to you?
- What is the severity? Is the potential loss meaningful to you?
Four Types of Events:
- High Frequency / Low Severity – There’s a good chance that this bad thing will happen to you. If it does occur, however, your financial situation won’t be meaningfully impacted.
- What to do: “Self-insure” through cash flow and savings. Dip into your emergency fund or rework your budget to cover the monetary losses.
- Example: A flat tire or regular auto maintenance.
- High Frequency / High Severity – In your circumstances there is a high chance of this bad thing happening. If and when it happens, the financial loss will be devastating.
- What to do: You’re up a creek.*
- Example: Flood damage to homes located in floodplains
- Low Frequency / Low Severity – This type of event is unlikely to occur to you, and if it did you wouldn’t care about the financial impact anyways.
- What to do: Don’t sweat it and go about your day.
- Example: The premature death of a healthy 30 year old without dependents.
- Low Frequency / High Severity – While unlikely to occur to someone in similar circumstances, if it did, your financial goals would be seriously derailed.
- What to do: BUY INSURANCE!
- Example: The premature death of a healthy 30 year old with dependents.
So you need insurance – now what?
Here are several common types of insurance, what they are for, and what to consider before buying.
- What is it: Protects against the risk of losing income due to becoming disabled. This is important coverage for most wage earners without other sources of income.
- Typically divided into short-term and long-term policies. Long-term disability insurance typically replaces income after the insured has been disabled for several months. Short-term disability covers the first several months of missing wages.
- Normally the short-term disability period would be covered by self-insuring and the long-term disability period covered by insurance.
- Understand how the policy defines “disability”. Some will only pay if any occupation cannot be performed and some will pay if one’s own occupation cannot be performed.
- What is it: Protects against the loss of income for surviving dependents due to a premature death.
- Determine the time period that the insurance is needed. Will the survivor be independent someday in the future or will you be able to self-insure at some point down the road?
- Term life insurance covers you a set amount of time, typically between 10 and 30 years for a fixed premium. It’s also typically the cheapest type of life insurance.
- Other life insurance types like whole life and universal life combine insurance with a savings vehicle. They are expensive and rarely appropriate for most people.
- There are some less common uses for life insurance outside income replacement including strategies for business planning and estate planning.
- What is it: These policies can cover several types of risks for property owners including protection against loss and damage as well as liability risk and medical risk.
- Liability insurance is required by law for auto owners and is essential for homeowners as well.
- Replacement coverage is essential for homeowners and auto owners with loans against their property.
- Collision insurance is required if you have an auto loan. If not, evaluate whether the replacement value of the car is worth the cost of the premiums.
- Smaller cost risks should be self-insured by having a high enough deductible (provided your emergency fund can cover it). That usually means $1,000 for auto and 1% or $10,000 for homeowners. The higher the deductible, the lower the premiums.
Long-Term Care Insurance
- What is it: Protection against the cost of services not covered by health insurance for everyday living for those with a chronic medical condition.
- This is one of the most difficult insurance decisions because long-term care is very expensive and often financially devastating. It is likely enough to be needed that the coverage is very expensive.
- Evaluate what resources would be left for a survivor if assets were depleted due to a long-term care event.
- What is it: Protection against the cost of incurring medical expenses.
- Common choices in health insurance coverage include the size of the deductible and the network of covered providers.
- For individuals without chronic medical conditions, a high-deductible plan is typically more cost effective and qualifies you for a tax-sheltered health savings account.
- Health maintenance organizations (HMOs) have fewer covered providers and more restrictions than preferred providers organizations (PPOs). HMO plan premiums are typically cheaper than PPO plan premiums.
Umbrella Liability Insurance
- What is it: Protection against the risk of liabilities that exceeds the limit of other policies.
- Property policies like homeowner’s and auto limit the amount of liability they will cover. Umbrella policies provide coverage beyond these limits.
- Everything you own could be on the hook in the event of a serious liability case. If you are worth $1 million and your auto liability is capped at $300,000, your assets are at risk.
- Umbrella coverage is typically inexpensive because getting sued is unlikely (for most people at least), and it’s a good idea for anyone whose assets exceed the liability limit on their property insurance. It’s usually a good idea to have coverage equal to or above the value of your assets.
Insurance types that aren’t normally worth the money:
- Child life insurance
- Pet insurance
- Extended warranties
- Accidental death and dismemberment (AD&D) insurance
There’s a balance between not over- or under-insuring. Having an appropriate cash cushion is the first and foremost insurance policy against many of life’s risks. Self-insure what you can realistically and don’t skimp on buying the insurance you truly need. Live long and prosper, but buy insurance just in case you don’t.
*In most civilized countries, we actually can protect against this type of event by collectivizing the risk pool and calling the premiums “taxes”.