Whether it is health insurance, car insurance, home owner’s insurance, or life insurance there is always a salesman on hand. Some are lizards, some are pitchmen, some are members of your church. Ask a salesman if you need insurance and he’ll proceed to tell you how you can’t possible get along without it. Knowing when you do — and don’t — need insurance is an important part of any financial plan.
So what exactly is insurance? Insurance is a way of shifting risk from oneself onto an insurance company. In buying a policy, you are paying the insurance company to take on your risk so that if something happens you won’t need to pay for things yourself.
Now obviously the insurance company doesn’t want to lose money, so they do a lot of calculations and run a lot of models to determine just how likely it is that the bad thing will happen to you during the life of the policy. Based on these calculations, they set the price of the policy such that they will receive as much as they will pay out in claims, plus a little more, for all of the policies they write.
In cases where the bad thing is almost certainly going to happen to you, it is just a question of when, you will actually be paying enough to pay for the event yourself if you save the money. For example with health insurance, because everyone goes to the doctor for physicals and occasional illnesses, the premiums you pay include an amount that is equal to what you would be paying if you paid yourself for those services. There is also a high cost service risk – the risk that you will need a liver transplant which will cost $1 million – built into the coverage. Because most people will not need such an expensive surgery in their lifetimes, the cost of that portion of the insurance is not as expensive as it would be if everyone would eventually have a major surgery. The insurance company might figure out that the chance was 1 in 100, and therefore you would be paying a little over 1/100th of the cost of the surgery in premiums.
Note that as more routine services are added to insurance, the cost goes up. Your insurance doesn’t provide free mammograms. You just pay for your yearly mammogram in your insurance premium. You don’t get free well-care checkups. You just pay for them in your premiums.
So when do you need insurance? You need insurance when the event that could happen would be beyond your means to cover with your savings and investments and still leave you with enough for life’s expenses. For example, when you a young married couple, you should have enough life insurance to replace the income of each working spouse. In addition, if one spouse takes care of the kids, maintains the house, or does other such things, you need enough life insurance to pay people to cover those services. A good rule-of-thumb is therefore that you should have enough term life insurance to cover 10 times your annual gross salary. For a child care taker, you should have about $500,000 in life insurance to pay for daycare and extended care should the caretaker die. Note that you should only buy term insurance since the high cost of whole life and other products are not worth the additional savings plan.
As a couple grows older, the kids are out and through college, and you hopefully have been following this blog and are a millionaire, the need for life insurance drops off. If you have saved ten times the wage earner’s income and enough to pay for the child caretaker, you really don’t need life insurance anymore. You are self-insured. Of course, the cost is usually so low for term insurance that you may keep some anyway.
With car insurance, if you were a millionaire and could pay for someone’s medical bills, you could self-insure. Unfortunately, since many people who had no money wouldn’t buy insurance, everyone is now required to buy at least insurance for negligence by law. Paying for insurance to repair your car, however, is optional. If you have the cash to buy a car to replace yours, you probably don’t need to carry this type of coverage. Of course if the car is old this coverage will be so inexpensive it may be worth buying anyway.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.