With investing people undertake risk with the hope of achieving a higher return. With insurance you are doing the opposite, incurring a cost to protect yourself from a major loss.
There are many forms of insurance. Some products are mandatory and others are optional. Oftentimes people may purchase insurance where it is not really necessary, but neglect to have it where they could be incurring significant risk.
Someone should realize that with insurance, on average you will pay more in premiums than you will get back from filing claims. An insurance company incurs administrative costs plus needs to make a profit to stay in business. Therefore, someone should never buy insurance with the expectation that they will come out ahead by doing so.
The whole reason for having insurance is to avoid events that could have a devastating impact on ones financial health. That is why we have fire insurance on our homes, and it is mandatory if one has a mortgage.
Interestingly enough, earthquake insurance is not mandatory when one has a mortgage. That is probably a key reason that only a small percentage of California homeowners have earthquake insurance.
In addition earthquake insurance comes with a deductible of 10 to 15 percent. That means someone having a $400,000 policy with a 15 percent deductible would not be covered for the first $60,000 of damage. Since most homes would not completely collapse in an earthquake, the high deductible is another deterrent for earthquake coverage. The structural soundness of one’s home is another factor to consider.
The federal government would almost certainly provide disaster relief, though it is doubtful they would provide the entire cost of rebuilding. An earthquake is the kind of major unexpected event that insurance is meant for. Before someone decides whether or not to have earthquake insurance the various financial ramifications should be considered.
Life insurance is appropriate for those who have families to support. It should be noted that Social Security does provide benefits to minor children where there is a death of a parent, so someone would only need this insurance to supplement what Social Security provides. Sometimes life insurance is offered, as a benefit through one’s work, and you would pay extra if additional coverage is desired.
If someone purchases life insurance outside of work, I would just recommend term insurance. Term insurance is relatively inexpensive, especially of the age range for people who have minor children. I would stay away from whole life insurance. Some people are attracted to whole life because you get some money back, unlike term insurance. However, the extra money that would be spent for whole life would be better placed in an investment account.
The types of insurance to avoid are extended warranties. These are huge money-makers for retailers. They wouldn’t be offering this product, unless it is profitable for them. The worst time to buy an extended warranty for a car is when you make the purchase. If someone is so risk averse that they feel they need one, you can always shop around for one later, since the car initially is covered under the factory warranty.
Managing risk is very important in our financial lives. That is why we diversify with regards to our investments. In the same way, we should look at insurance from the standpoint of whether the cost being paid, is reasonable for the potential risk that is being avoided.
This column only covered several of the various insurance products that there are. I will go over some of the other major ones at a later time.