The Proper Use of Insurance
Updated: Nov 16
Insurance has a reputation as being a product that nobody buys but that is instead sold. This is unfortunate as insurance is often one of the critical building blocks of a stable financial plan. Without proper insurance, many households are only an accident or illness away from financial ruin.
But many fail to understand when insurance is appropriate and, equally important, when it is not. This situation is partly due to many insurance agents' attempts to sell any and all types of insurance policies even in situations where they are inappropriate. Insurance can also be a confusing topic due to the terminology used, the large number of variables that can be involved, and the reality that there are seldom, if ever, bright lines to indicate how much insurance one truly needs.
Understanding how insurance works and the primary purpose of insurance can go a long way to helping individuals sort out what types of insurance they might need along with how much and when.
According to the Insurance Information Institute, the intent of insurance is to "reduce financial uncertainty and make accidental loss manageable." This happens through risk pooling, where risk is shared across a large group of people (or organizations). This involves these people (aka 'policy holders') paying premiums into the pool, and those premiums are then paid out from the pool to those who experience the risk. Insurance companies run these risk pools, but the premiums they charge do not all go toward paying for the insured risk; a portion of the premiums must also be used to pay the company's administrative expenses of their operations and, in most cases, provide a profit for the company.
Those who can accept the financial risk of a given event themselves rather than transfer that risk to an insurance company, their expected costs are lower because they do not have to pay for the insurance company's administrative expenses and profit. 'Expected' is the key word here because if the risk occurs, it's likely that these people would have been better off financially had they bought the insurance. But most of the time, the risk does not occur, and accepting the risk leads to a better financial outcome.
Consequently, if an event's occurrence would not cause you financial ruin or even hardship, you generally should not buy insurance to cover that risk. Rather, you should 'self-insure' that risk (i.e., take the risk yourself rather than transfer the risk to someone else via insurance), and if it occurs, you simply pay its financial cost.
Insurance should primarily be bought to reduce the risk of financial hardship.
As someone once said, the purpose of insurance is not to help you get rich. Rather, it is to help you from becoming poor.
Insuring one's home is nearly always a very wise decision (if there is a mortgage on it, insurance will be required by the lender) since its loss would likely be a financial hardship for most people. Life insurance that would provide a large sum to those who are financially dependent on breadwinners is often a prudent move.
Conversely, insuring one's cell phone is seldom a good decision since its loss would rarely be a hardship. Life insurance on young children rarely makes sense because if a child passes away, there is seldom a financial burden on the parents.
This does not mean that insurance should always be avoided in situations where a risk's occurrence would not cause financial hardship. For instance, there are times when the cost of insurance (premiums or the cost of an extended warranty) is lower than our expected benefit. In my own family's case, we started hearing odd noises come from our dishwasher about one month before the one year warranty on it would expire. We have had many issues with dishwashers already, so when the manufacturer offered for us to extend the warranty on it for another for $69, we bought it since both the cost of getting it repaired would be significantly higher than that and the likelihood of it needed to be repaired was high. And sure enough, the dishwasher failed a couple of months later, and a repairman had to replace its motor.
Also, some choose to buy insurance to avoid being forced to sell some of their investments at a poor time (e.g., if their investments are in a significant drawdown) or when doing so would incur significant taxes.
Those who elect to self-insure should be prepared to pay for the expense if it occurs. Some do this by holding an 'emergency fund' with enough to cover such costs. We have chosen instead to contribute every month to a 'irregular and non-monthly expense' account, which will be the topic of a future post.
Rather than trying to buy insurance, extended warranties, and the like to insure every possible event that could affect us, we should rather insure those risks that could be financially detrimental to us if they occurred and be prepared to self-insure the myriad other financial risks that we face.