Personal Finance Concepts You Should Know – Concept 3: Insurance

River1Understanding insurance it critical for managing your finances.  Some insurance products just aren’t worth the price.  Others are critical to have during different periods of your life or you could find yourself destitute.  Here are key concepts to understand:

What insurance is

Let’s say that you lived on a street with 100 houses.  You noticed that, on average, there was one house fire every ten years.  You and your neighbors might get together and decide to put some money together to pay for someone’s house if there is a fire (provided, of course, that the fire was not intentionally set).  If each of the homes cost $250,000, the amount you would need to pay out per year would be $250,000/10 years = $25,000.  Since there are 100 of you, you would each need to pay $25,000/100 = $2,500 per year to provide the money needed to pay for the house fires.  You might choose to do this since, while the chances of a fire actually happening are only 1/(100*10) = 0.1% per year, you would not have the $250,000 needed to rebuild your home should a fire occur.  This is what insurance is – people pooling together their money to pay large amounts of money to a few individuals for relatively rare events.  Insurance is generally for things you never expect to happen and usually are happy when they don’t.  Note that if you held your home for 100 years and paid the $2500 each year, you would have paid for the full value of your home.

When you add an insurance company to the scenario, things really aren’t that different.  In our example above, you might have decided to pay one of your neighbors to handle the money, including the payouts, the accounting, and the tax preparation.  In exchange, you each might pay $2750 pre year to cover a salary for the neighbor and his costs.  This is really what the insurance company is doing.  Because a fire only occurred every ten years, the manager might also choose to invest the money in the stock market or real estate so that he could make a return off of the money while it was just sitting there.  This is really where the insurance company makes their money – it is not from the premiums you pay which might cover salaries and costs but would not provide any profits to the insurance company.  If they did charge a lot more than their costs, another insurance company, knowing that they could make a good profit from investing the money, would charge a lower premium so that you would give your money to them instead.

What is not insurance

The two factors that make insurance real insurance are:  1) The event you’re insuring is unlikely to occur and 2)if the event were to occur, it would be devastating financially for you.  There are products that are called insurance, but they really are just prepaid plans.  An example of this is heath insurance.  There is a component of health insurance that is true insurance – the portion that covers you if you develop cancer and end up undergoing $1M in treatments – but most of the money you pay is just prepaid healthcare.  You pay the insurance company for the doctors visits and prescriptions that you are very likely to need during the year.  Some people use more healthcare, so they end up paying less than they cost the insurance company, while some people use less, but on average people pay what they would pay to the doctors anyway.  Actually, you pay a little more than you would if you just paid the doctor directly because you need to pay for the staff at the insurance company and the extra staff the doctor hires to file the claims.  The two factors listed above do not apply since you are likely to have the event occur (for example, you’re almost certain to have a physical each year unless you simply choose not to have one) and the event is not financially devastating (it might cost you $60 for an office visit and maybe $100 in labs if you were to just pay on your own).

When to buy insurance

You buy insurance when the event would be financially devastating.  You buy homeowners insurance since it would take you a decade or more to save enough money and buy another home should a fire occur.  You buy major medical insurance since a liver transplant would probably drive you into bankruptcy since few people have an extra $500,000 sitting around.

When to not buy insurance

You should not buy insurance when the two criteria above are not true.  If the event is very likely to occur, you should just save up money and plan to pay for it.  If the event would be an annoyance instead of being financially devastating, you should just self-insure, meaning that you’ll just pay for the event should it occur, and save your premium money.  The one exception here would be if the cost of the insurance is so low that it really doesn’t matter anyway.  For example, someone with $10 M in investments might choose not to insure a $200,000 home because he could just buy another if a fire occurred, but since insurance might only be $1500 per year anyway, it would not really matter to him if he paid for the insurance.  Yes, he would be paying a little more this way (if you look at the odds a fire will happen and the cost to rebuild the house) than he would if he self-insured.  In ten years, however, he would have only paid out only $15,000 in premiums, which is very little compared to the $6 M or so he would probably made on his investments.  If a fire did occur, he would probably feel better to use insurance to rebuild the home than he would if he had to pay cash himself.  He also might have things invested and not want to sell investments to raise the cash since this creates other expenses like commissions and taxes.

Insurance you really need

Term Life Insurance:  Before you are married and have kids, there is little reason to have life insurance and you might choose to go without.  You might also choose to get a small, $10,000 policy to pay for your funeral should you not want your parents or someone else pay to bury you and you didn’t have enough in possessions and savings to cover the expenses.  After you are part of a family, however, you have people depending on you who would be financially devastated should you die suddenly.  If you work, you need to have ten times your annual salary in life insurance so that your income could be replaced through investments.  If you take care of the kids and the home, you need to have about $500,000 in insurance to pay for a nanny and maid service should you pass.  When you are young this type of coverage will be less than $300 each per year for a 15-year term policy.  By that point, hopefully you’ve saved up enough to be self-insured.

Car Liability Insurance:  OK, you need this by law, but it would also be devastating to get into a wreck where you injure people and end up paying several hundred thousand dollars in hospital bills.  You also might end up paying for an expensive car if you hit the wrong person.  You may think you can’t afford auto insurance, but if are paying for a cell phone plan instead of car insurance, for example, your priorities are out of order.

Homeowners insurance:  We’ve already discussed the need for this.  You are required to have home insurance while you have a mortgage since the bank wants to be sure you’ll pay them back.  Once you become financially independent and paid off your home, you could go self-insured, but it really doesn’t cost that much for the piece of mind.

Major medical insurance:  Unfortunately, you can’t buy just major medical insurance anymore since the passage of the Affordable Care Act, a.k.a. Obamacare.  While you don’t really need to have insurance to cover routine care – you should just put money aside to pay for it – you do need coverage for long hospital stays.  Since it looks like Obamacare is likely to collapse, maybe we’ll get back to the point where we can just buy major medical policies.  Otherwise, electing the right people and holding them to their promises could cause the law to be changed.

Insurance you don’t need

Whole life insurance:  The returns you get from turning your life insurance policy into a saving vehicle are awful, plus you generally lose your savings account should you die and use the policy.  Skip the whole life and go for term instead.  Just stick the difference into  a mutual fund and you’ll be much better off.

Cell phone insurance:  At more than $100 per year, phone coverage just isn’t worth it.  Also note that many plans require a $200 deductible, so you could just buy a $200 phone if you drop your phone in the toilet.  (Why do people need to use their phones on the toilet?)  Just buy a protective case.  You might also consider buying a phone separately rather than getting the “free” phone where you actually pay for the phone over the next few years with higher monthly plan costs.  That way, should something happen, you won’t end up paying for the phone you no longer have for the next several years.

Routine medical care insurance:  Again, you now have no choice here, but you could help change things if you vote and express your opinions to your representatives.  You would be much better off just giving the doctor cash when you went in for your check-up.

Renter’s insurance:  While it stinks to be robbed or have a fire destroy your stuff, the chances are low and you can recover from a few thousand dollars in losses to clothing and stereo equipment.  Instead invest in a good lock, an apartment in a better part of town, and maybe a dog.  Or maybe move in somewhere the neighbors have really nice stuff.

Home warranties:  Again, this covers things that will happen eventually, so you’re paying a premium when you buy a policy.  Instead, put money away each month for the home repairs and appliance replacements that will eventually come.

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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.

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