This post is inspired by a reddit discussion. The topic was on insurance, the basics of it.
Do we give proper value to insurance in our life or we just go on routinely on insurance? When you earn a bonus at work, do you consider increasing the insurance amount to have more coverage. When you get a raise do you consider increasing your premium and cutting on the out-of-pocket expenses?
What is insurance and why we need it, is rarely discussed on personal finance websites and blogs.
Those who want to just know how much insurance they should have maybe disheartened, as this post is to guide decide that on your own. We will not talk about how much insurance you should have, we can’t do that as everybody is different and what works for me may not work for you.
We would rather talk about and set a general guideline that can help us determine our insurance need on a high level. This post does no way suggest your specific insurance coverage amount. Let’s start with ‘what is insurance’.
What is insurance
Insurance is all about playing defense, where as an investment is an offense. You protect yourself and your asset by having insurance. You score over life’s future needs by investing your money. That team is strong which has both the defense and the offense strong. You can’t ignore one for the other. One of the basics of personal finance is to have adequate insurance coverage
There are three key things to understand insurance; Assets, lifestyle, and risk appetite.
Insurance really covers three things. Your belongings (property), your liabilities, and your body (health).
Most basic insurance coverage is property coverage. You pay a premium to have a certain piece of property covered in case something happens to it. Whether it is your iPod, car, house or your McMansion.
Do you need to get more property insurance? I suggest people get insurance on things depending on how difficult it would be for you to replace it. If you are poor you can buy warranty on certain electronics, its kind of insurance against any damage to your electronics, as it would be very hard for you to pay the replacement cost otherwise.
Yes, you pay more up front for the cost of property and the warranty cost, but in case of something going wrong, it is covered. As you build assets and you get richer, your need changes you may not need a warranty on your Xbox as you can get a new one without hurting bank balance much.
What about your car? You can’t get away with this, every state requires you to have a car insurance. Also there’s no limit to how many cars you can damage and how many bodily injury can occur when you are at fault. At least for the peace of mind, you should have state stipulated minimum insurance coverage on your car. Else, it’s a crime driving without insurance.
Home owner’s insurance is next. Determine how much of the house you can replenish from out-of-pocket. People like I am, who belong to the middle class, can not replace a $300,000 home without an insurance. So, we need insurance that fully covers the house replacement cost, or at least a major part of it.
More assets you have, more insurance coverage you’d need, unless you have so much assets that you don’t mind replacing.
Now we look at lifestyle aspect of insurance. If you live in a one bedroom home, you’ll need lesser insurance coverage than the person living in a two bed room home.
How much insurance do you need if you have a car, but you rarely use it? Probably not much. On the other hand are you or someone in your family is suffering from an illness? You better increase your health insurance coverage.
Do you have a teenager who got a couple of speeding tickets already? you should look at increasing car coverage.
Nothing is constant in our life. Our health, our family and our assets are all risk prone. One day you are perfectly healthy and the very next day you get sick. So is your home. a fire can burn down it down in a few minutes. You car can be in an accident. You’ll suffer monetary loss in event of any of these.
An insurance minimize that risk. When something happens to you or your assets, your insurance pays you back. This is risk mitigation by means of having an insurance coverage.
More risk you have more insurance you need. Putting in a better way, the less risk appetite you have, the more insurance coverage you need.
Is insurance Required? opposing view
On average, insurance is a negative sum game for the policyholders. The value of premium is calculated after adding up probable claim amount, administrative charges, other fees, taxes and profit for the insurance provider.
The average policyholder will pay more in premiums than he/she can reasonably expect to get back from the policy. This is how insurance companies make money.
Here’s some example from our coverage perspective.
- We pay $7,000+ per year on health insurance, in a 40 year career we will pay $2,80,000 in health insurance, which if otherwise invested in a long term stock/fund portfolio would have resulted in $1.4M at a 7% return. Do you think you and your family would require that much medical cost to keep living?
- We pay $210 in vision insurance. basic eye exam is free, not the reliable ones like glaucoma etc. If we do not get a lens and a frame each year, we will make loss. I am sure many of you are making a loss already.
- We pay $1,200 for car insurance each year and so far we have made no claim from the insurance. this money is going down the drain. Guess what, my deductible is $1000 as I have sufficient emergency saving to cover it.
- Only life insurance premium/coverage ration is favorable. And, that’s because you can only die once!
- Before cancelling, we were paying $10 per month on renters insurance. 120 per month for nothing! we do not keep any valuable at home, they are safely stored in bank locker. We do not have costly appliances. Major home appliances are covered under landlords coverage. We were just kicking the money away.
When you just started thinking that you don’t need an insurance coverage, do remember the basic need of insurance – to lower the risk. If a sudden illness requires you to be in hospital for more than a few days, without adequate insurance coverage, you’ll go bankrupt. So, I just can’t drop that health insurance coverage.
Also, buying any thing is a money losing deal as the money you pay is value of the good (or service) and profit for the seller. Insurance is no exception.
Insurance provides an umbrella to cover you during those exceptional circumstances. You can’t just dump an insurance coverage.
Insurance is a lucrative business, companies make profits (lately there were some exceptions, but economy had to suffer anyway) by selling you insurance. They make profit out of my insurance premium and your insurance premium. We lose in this negative sum-game.
It really takes a professional to help guide you on the finer aspects like determining adequate coverage. I have my own agent.
You must consult with your insurance agent before making any decision. While choosing the agent exercise care and select someone whose advice you can almost blindly follow.
This post was part of my learning to understand dynamics of insurance, which I always found boring and vague. Now, after all the reading and writing, I just want to sing “It is insurance, and I know it!“, “I read out!” 🙂
Nice coverage SB. In my opinion, insurance companies should be non-profit organizations (like Vanguard in the brokerage business). That would be one way of keeping costs low and keeping the focus on the consumer rather than the shareholder.
Its like overhauling the financial system. millions of shareholders would be affected. No doubt its a noble idea and but not sure if there will be any takers among those who make decisions like this.
Paul @ The Frugal Toad says
I can’t imagine not having enough life insurance to provide for my children. It is so important to provide the resources for your loved ones in case you are not there.
Yes very true Paul
Your mortgage company will require you to prove that you have adequate home owners insurance before they lend you any money. (At least, I had to prove it – I have an FHA loan and only put 3.5% down though. It could be different if you put more money down.)
Also, for college students, your parents’ homeowners insurance may extend to cover insurance on your stuff in your rental property. But don’t forget about getting renters insurance if you don’t have this safety net! I had some college friends whose apartment building burned down, and they had no recourse to replace all of their things – laptops, furniture, ipods…
I am glad you are at least not paying the mortgage insurance which I believe is must f your down payment is less.
This Aggie Saves says
Renter’s insurance isn’t worthless, it covers everything you have, regardless if you feel your only valuable items are already safe locked away at the bank. Clothing, jewelry, appliances, furniture, electronics-it all adds up. There’s no way I’d forgo renter’s insurance.
I see the positive and negative aspects of the renter’s insurance. But I would say, take decision based on the value you leave behind at home. For me not much, the furniture and electronics can be replaced without costing too much.
Broke Professionals says
First, I love the offense/defense analogy – it makes so much sense, yet you’re the first person I’ve ever seen use that!
Second, I think health insurance is so critical. I have a cousin who gave birth to a baby at 24-weeks along. The health care costs surrounding his first year of life ALONE were more than $2.5 million. If they hadn’t had health insurance, they’d have had to file for bankruptcy; instead, they only had to pay a $2500 co-insurance bill.
Welcome Obamacare! I covered this topic a few days back. Health insurance in this country is as important as having a life insurance.
Kim @Money and Risk says
Good explanation SB.
Just remember though that insurance is there primarily to protect you and pass the risk. Think of it as a risk analysis/payoff and it will make better sense.
Also, insurance is one of the best form of leveraging for wealth. Keep in mind, there’s a reason why it’s heavily used by extremely wealthy individuals.
Agree to all of these, as I said insurance is like defense, always there to protect your wealth and sanity.
Robert J Hardy says
Thank for providing this information. People don’t know the value of insurance protection. Your post will help people to find the reason of buying insurance protection. Insurance is a way of managing risks. I think everyone know that life is uncertain. Insurance provide protection for yourself, your investment and your business. Anything can happen like car breaks down, roof leaks, home fire that leads to a legal action and someone in the family becomes ill. Insurance gives you peace of mind and you know that if anything happens to you, your family or your business that you will be financially secure.
Gregg Montgomery says