Problem #37: I don’t understand how insurance works. What is the purpose of insurance, and how much insurance do I need?
What is the purpose of insurance in your life? First, did you know, you can buy insurance for anything? I do mean anything . . . Check out this Wikipedia page! I’ll wait . . . .
Did you notice the same thing I did? Alien-Abduction Insurance . . . Really? Come-on people! At least think a little bit. If you were abducted by aliens, do you really think you’d be able to come back and collect? And if the aliens did return you (out of the kindness of their hearts – if they have hearts), do you think you’d actually remember and be able to prove that you were actually abducted? In this case, this insurance is – Say it with me – Waste. Of. Money.
But is all insurance a waste of money? What insurance do I actually need? What is the purpose of insurance? Do you have an insurance PROBLEM?
Want a cheat sheet to refer back to later? Download a great summary of the common types of insurance here – for free!
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What’s the Purpose of Insurance?
Before we decide how much insurance you need and what kinds are important, we need to discuss insurance in general. Let’s start with the purpose of insurance – all insurance. It’s intent is to repair or replace something . . . anything that you can lose. And I think we all know that anything you have – you could lose. I hate to be a Debbie-Downer, but it’s true. Just consider that your reality dose for today. “You could lose everything.” Bottom-line: if you can’t afford to replace or repair something, insure it! . . . for a small price you can insure just about anything!
Can You Explain Premiums and Deductibles?
An insurance company agrees to take on the risk of repairing or giving you the replacement value of whatever you insure. You pay them an agreed amount monthly or yearly for this risk transference. This is called your insurance premium. It’s important to remember that the purpose of insurance is for risk transference!Insurance is intended to transfer Risk away from you - which comes at a cost. Click To Tweet
If you agree to pay an initial amount of replacement value or repair costs of what ever you insure up to say – $500 – this is called a deductible. When you increase your deductible, the insurance company will lower your premium. This could save you money, unless you have a claim where you have to use your deductible. Note that if your repair cost is less than your deductible, you have to cover the entire cost of the repair yourself.
Every situation is different, and your risk tolerance might be different. So you will have to weigh whether you would rather pay more upfront to the insurance company (premiums), or risk paying more later in the form of a deductible.
How Do Insurance Companies Make Money?
You may ask, “How can they afford to pay to replace my house for example, if it gets destroyed in a tornado?”
Insurance companies make money, and they have money to pay out for different claims (when you ask for money to replace or repair something), because they have many customers who have purchased their insurance. Basically, everyone that buys insurance pays into a huge pot of money. Only a few people actually file claims, so the amount of money coming in (premiums) is much more than the insurance company has to pay out.
When they start paying out more money in claims, your premiums will rise. The larger their customer base is, the less you’ll notice this, as they can spread out these costs over many, many people.
They use statistics and math to figure out what their risk will be by insuring you, and how much you should pay for this risk transference. Depending on your situation you could end paying more or less than someone else for the very same coverage!
They are also very stingy in paying out claims. If you’ve ever tried to file a claim for any insurance, you know what I’m talking about.
Here’s a list of common types of insurance:
- Mortgage (known as PMI)
- Long-Term Care
- GAP (for new car purchases)
- Various Types of Business
- Extended warranties
Do You Need All these Types of Insurance?
In short – No. Remember, the purpose of insurance is to replace or pay for something that was lost. But since you do have to pay for insurance, we need to evaluate whether it’s actually worth it. There are two questions to ask when it comes to insurance.
- Can you afford to repair or replace that ‘thing’ yourself? Either with your emergency fund, or perhaps some other savings.
- How much do you have to pay over the life of the insurance policy? In other words – if the insurance policy lifetime premium (the total amount you pay) is more than the actual value of that ‘thing’, it doesn’t make sense to insure it. If you lost it, you would simply replace it yourself. It isn’t always that simple, but remember – you’re transferring risk. How much is that worth to you?
Related: You need an Emergency Fund.
Insurance that you should have or perhaps are required to have.
If you have a mortgage on your house, homeowners insurance is required. The bank wants to make sure they can recoup their investment if your house is destroyed. Flood insurance may also be required depending on your location. Note that if you payoff your mortgage you should still have homeowners insurance. Your house is a very expensive asset to replace if it were lost. Don’t risk it! But you could save money by increasing your deductible. However, you need to have the money available to pay the deductible if necessary.
You should also have renter’s insurance – if you are renting. This type of insurance will cover your belongings in your rental if something were to happen like a fire or other apartment damage. This insurance is usually cheap – maybe $70-$120 per year – depending on where you live and how much you insure (typical is $10k – $20k). Consider if your apartment were to burn down (trust me – it happens more than you think), do you have the funds to replace your life? And do you want to pay to replace your life? I didn’t think so. Get it!!
There are several types of car insurance – comprehensive, collision, and liability.
- Collision – covers your vehicle in the case of damage in an accident.
- Comprehensive – covers your vehicle in the case of damage by other events, think – a tree falls or vandalism.
- Liability – covers other people who incur expenses in an incident involving your vehicle.
The rules vary by state, but in general it is a good idea to have at least liability car insurance – it is required in many states. Collision and comprehensive may also be required if you still owe money on your vehicle. As with homeowners insurance, you could save money by increasing your deductible. But the same also applies – you need to have money available to cover the deductible if necessary.
If your car is not worth much (couple thousand or less), collision insurance might not be worth it – depending on the premiums. But, your premiums can be affected by multiple things such as your driving record, age, and location among other things.
To save money, shop around for different quotes. It only takes a few minutes on-line. You might find you’ve been over-paying for coverage.
Medical bills are one of the biggest causes of bankruptcies in the United States. Most people cannot afford (without insurance) even a short hospital stay for a routine procedure (could cost close to $10k). I realize that health insurance is one of the most debated (in Congress) topics, but the bottom-line is: if you have the opportunity, you need health insurance. You can’t afford not to!
Some employers will offer dental and vision insurance as well. Dental insurance is a good buy. Not everyone needs vision insurance, but this is usually also a good buy.
This one is bit tricky. Not everyone needs life insurance. It depends on your situation. Life insurance is intended to replace the income of someone who passes away. If there is someone who depends on your income, like a spouse, kids, other family members, then you need life insurance.
The amount you need depends on your income. In general you need 10-15 times your current annual income. Assuming a 6-10% return, you should be to replace your income with the growth or interest generated from investing the insurance payout. The best and cheapest way to get this much life insurance is to buy term insurance. Most employers offer some level of term insurance also.
Never use life insurance as an investment vehicle. Invest your own money, don’t let the insurance company do it for you.
This insurance will replace a portion of your income in the event of an unexpected illness, injury or other event that causes you to miss work. Usually, you receive 40%-60% of your pay. So your income will drop, but it’s better than no pay at all during a difficult situation.
Short-term disability insurance is usually covered by your employer. I would not recommend long-term disability, but it would be up to you. Are you accident prone, or are you risk averse? If so, get it. This type of insurance can sometimes be a life-saver, but for others it may be a waste of money.
Long-Term Care Insurance
This type of insurance covers you in the event you need to spend time (think – your last years) in a nursing home or similar. If you reach retirement age with plenty of money to retire (and then some), this insurance is probably not necessary. If you enter a nursing home in this situation, your estate will cover the cost of the stay.
The average cost of nursing home stay is $60k – $80k per year. And the average stay is 3 years. If you are 50 or older, you should look into this insurance. Depending on your financial situation, this may be a wise decision. If you can cover the cost yourself, then this insurance is not needed.
Evaluate your situation based on your health, and the health of your finances. Will you have $300k left towards the end of your life – to cover a nursing home? Or will your nest egg be totally depleted? What is the cost of the insurance?
Types of Insurance you should Not Buy.
Pretty much every other kind of insurance. No seriously – you don’t need any other insurance except maybe an emergency fund.
Your emergency fund is insurance that covers many of these other situations. Your pet needs a procedure – emergency fund. If you need to replace a broken appliance. You don’t need an extended warranty or repair insurance. Use your emergency fund. If you lose your job – emergency fund – until you can get back on your feet.
Are you starting to see how important an emergency fund is? It provides the financial security you need – for those just-in-case moments. You don’t need to worry about all those other types of insurance if you have a good emergency fund.
Related: You need an Emergency Fund.
The purpose of insurance is to transfer risk away from you. For high dollar value items (house, life, car, and medical situations), insurance is well worth the cost. It can save you from bankruptcy. But don’t go overboard. You don’t need other incidentals insurance. If you invest in a good emergency fund (3-6 months of expenses), this is insurance enough.
Are you over-insured? You might be able to save money if you are willing to take on some of the risk yourself.
How much insurance do you have? Let me know in the comments below.
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