When Should You Insure?
A few weeks back I received a question regarding when to purchase insurance. One of the mistakes that many individuals often make when it comes to purchasing insurance is failing to do so within the context of the bigger picture. It’s common to see people make one-off financial decisions – an insurance policy here, an annuity policy here, another savings account there - without considering their overall goals and how each of those tools work together and in some cases overlap and cancel each other out. What I want to do in this article is discuss not only when you should insure, but also how to approach purchasing insurance from a well-informed, eyes-wide-open standpoint.
When it comes to purchasing insurance, the first questions I tell my clients to ask is “what are you insuring?” followed by “how likely is that event to happen and what are the consequences?” Often, individuals just assume that insurance is important, so they go out and buy it. Insurance is important, but purchasing it without fully understanding your situation can lead to a lot of wasted premiums. A few years back I met with an insurance agent as a favor to a friend and let him practice his sales pitch on me. During the course of the meeting, he tried to convince me that I was in desperate need of life insurance to protect my loved ones, to which I responded that I had no children and a husband with equal earning power to myself who would be perfectly fine financially if anything were to happen to me. Not only that, but we had no major debt outside of car payments, and nothing catastrophic would happen to either of us financially if one spouse were to pass. Simply put, at that time I had no need for insurance. There was nothing to insure against. Now that my husband and I are expecting, the situation is different, and we are researching what our options are in regards to providing for our child in the event that something should happen to us. We now have something to insure: our child’s well-being. Now that we’ve answered the first question, we can move on to the next: how likely is that event to happen (both of us passing) and what are the consequences?”
The following chart is provided for individuals studying to become Certified Financial Planners and I personally find it very helpful with regards to the insurance decision:
With regards to life insurance, the risk that both my spouse and I will die is infrequent (I’m hoping that doesn’t happen for a very long time), but the consequences are very severe (my child will be left without parents). This is a good instance in which I should consider insurance. Before, the financial consequences were not severe (I had no children and my husband would have been fine) in which case the chart leads me to maintain risk or do nothing. The risk of me dropping my phone is frequent, but the consequences are not severe and I can reduce risk by purchasing a protective case. Hopefully, you get the picture of how the chart works. It allows us to answer the next two questions. It is unlikely that both my spouse and I will pass, leaving behind a child, but because the consequences are very severe, we need a plan. That means it’s time to consider insurance (within the context of our overall financial goals of course).
Insurance contracts are tricky. They are one of the few instances where reading the fine print really is important. Please do not go out and purchase the first insurance product someone offers you. Investigate. Understand what it is you’re getting and exactly what it is you are paying. One of the things I dislike about insurance products is that they are often full of hidden fees and if-thens, instances where “if” one thing happens “then” something else happens, but those instances aren’t very clear up front. Clarify the if-thens for any and all situations you can think of by explicitly asking the agent, “If this occurs what happens? If I die, what exactly happens? If I don’t die and the product terminates what happens? If I want to increase or decrease the amount of insurance I have at any point what happens?” Most insurance agents are counting on you to be too confused by the contracts to try to poke holes in what they’re selling you. Be smart. Be confident. Ask questions. Understand exactly what you’re paying up front for the product and on an annual basis, what the penalties are for terminating early or taking money out, and if there is any cash value to the product. Fees are a huge part of determining a good policy from a bad policy, so know what you’re paying.
When it comes to how the policy works itself, understand that an insurance policy is not the same thing as investing in the market. An insurance policy is a contract. It’s an agreement between you and the insurance agency to receive money in response to a certain event. Every now and then I hear stories of insurance agents selling “special/magical investment opportunities” that allow you to get the upside of the market while avoiding the downside. This investment doesn’t exist. If it did we’d all be doing it and looking like geniuses! You can, however, agree to a contract where you give an insurance agency your money in return for the upside of the market for a fee (and often commission for the salesperson). The insurance agency then takes your money, does a bunch of math, and tries to invest it in such a way that they make enough money to pay themselves and to keep their agreement with you and everyone else. They are not, however, investing in a special/magical investment vehicle. When it comes to how your contract is written, don’t forget to consider the rest of your financial situation (remember - holistic planning). If you have other accounts invested in the market earning market returns, then you probably don’t want an insurance policy that does the same but at a more expensive rate. By and large, insurance products are meant to fall on the conservative spectrum – they don’t make you rich, but they keep you safe. Do your research when it comes to finding the best policy and paying the right price for it, and make sure that your insurance policy is aligned with the rest of your financial goals.
*chart used with permission from money-eduction.com
(This article was originally published August 17, 2016, on our sister site The Cupcake Club).