Intro to Insurance

Attitudes Toward Insurance

Insurance coverage can be tricky to shop for, because it requires making specific
financial decisions about some hazy and unpredictable concepts. Depending on the
type of insurance you’re looking into, you might find yourself pondering some downright
uncomfortable questions:

• What would happen if I get sick the day I’m supposed to leave for the three-week
European vacation I’ve been planning forever?
• What would happen if a major earthquake damaged my home? If my basement
flooded? If there was a fire in my apartment building?
• What would happen if I became so ill I couldn’t work any more?
• What would happen if I had a break-in?
• What would happen to my family if I died tomorrow?

And just in case following this worst-case-scenario thought spiral isn’t depressing
enough, figuring out the right amount of coverage also requires some awkward
speculation: how much, in dollars, would it cost to “replace” you in the event of a tragic
accident? What’s the total value of every single thing you own? If you were disabled to
the point of not being able to work, how much money would you need in order to get by
for the rest of your life? These questions are hard to think about and even harder to
answer. Mixing the matter-of-fact nature of finances with the randomness and
unpredictability of life is a complicated process.

Although individual insurance policies and coverage details can seem endlessly
complex, the fundamentals of insurance coverage—and your attitude towards it—can
be simple. Understanding the expectations you have of your insurance policy can make
much of the confusion and second-guessing disappear, so that you can focus in on
what you truly need from your insurance provider.

Insurance is not an investment

Many people automatically categorize insurance coverage as a complete waste of
money, especially if you never end up needing it. Let’s take a moment to think about
how backwards that is. Using that logic, in order to get your money’s worth from your
insurance provider, you would need to make a huge claim. But here’s the thing: in order
to make a huge claim, you would first need to suffer a major loss, and major losses
typically result from unfortunate events. If you expect your insurance payments to act as
an investment, you’re basically hoping for a natural disaster, property damage or
serious illness—or worse.

Adding to the confusion are plans like whole life insurance policies (or return of premium
policies), where if you outlive the term of the policy, the money you’ve paid in premiums
is returned to you. This may or may not make sense for you personally for many
different reasons, but return on investment should not be one of them. Insurance is not
an investment; insurance is protection, and therefore needs to be prioritized differently
from investment products in your personal financial plan.

Insurance is a transfer of financial risk

So if insurance coverage isn’t an investment, what exactly is it? When you take out an
insurance policy, what you’re actually doing is paying your insurance provider to take on
your financial risk regarding a specific situation outlined in your contract. Consider this:
your insurance provider fulfills this responsibility whether or not that specific situation
ends up taking place.

As an example, let’s say you have a car insurance policy that, among other things,
includes coverage of any damage resulting from a tree falling on your car. Let’s also say
(for the purpose of this example) that, statistically, there’s a 1% chance that a tree will
fall on your car this year. By paying your annual premium, you are transferring any
financial consequences associated with that 1% risk over to your insurance provider. If a
tree falls on your car (a rare scenario), the insurance provider reimburses you for the
damage. If a tree falls on your car 12 times throughout the year (a very rare scenario!),
the insurance provider would reimburse you each time. If zero trees fall on your car this
year (the most likely scenario), there is no tree-related damage for the insurance
provider to reimburse. In all three of these outcomes, the insurance provider is still
assuming that 1% risk. You pay your insurance provider to hold up its end of the deal,
and the provider is doing that, whether or not a tree ends up falling on your car.

Insurance protects against losses

When shopping around for insurance coverage, it’s best to think of your policy as simply
a way to cover a significant financial loss—and significant is the key word.
Purchasing insurance for something that you could easily replace yourself in the case of
a loss (like a $20 set of earbuds) doesn’t make a ton of sense, because it often costs
you more to have it insured than to just assume the small financial loss yourself, should
you need to replace it.

The same goes for expenses that fall under the emergency fund category. Though
emergency funds share some of the same roles that insurance policies do (financial
protection from unexpected circumstances), they are not interchangeable, and a solid
personal financial plan requires both. Emergency funds are designed for situations that
realistically will happen eventually (a stretch of unemployment or a car breakdown),
even if the “when” and “where” are unpredictable. These emergency situations can
usually be smoothed over with a few thousand dollars’ worth of emergency fund savings
—it’s a lot of money, but it’s not an impossible amount of money.

A significant financial loss, by contrast, is a seemingly impossible amount of money to
recover—tens and even hundreds of thousands of dollars. A significant financial loss is
the kind that would literally change the course of your life and the lives of your
dependents. It’s for those losses that insurance coverage offers the best protection.
The more realistic you are about how much a particular loss would cost you, the better
you’ll be able to articulate your insurance needs when shopping for a policy. Instead of
blind guessing, put a little bit of thought and research behind your estimates. If you’re
considering fire insurance, for example, you might start by doing an inventory of the
contents of your home—but you should also consider researching the cost of
construction in rebuilding a home after fire damage.

Insurance policies are complex, but your attitude towards them can be straightforward.
Insurance policies are not designed to grow your money—they’re designed to protect
you and your family from significant loss by transferring your financial risk associated
with a specific set of unpredictable circumstances. It’s up to you to determine which
unpredictable circumstances warrant protection (and how much protection to have in
place), but by simply identifying the role of insurance in your financial plan, you’ll be
better prepared to make smart decisions about what to insure.