Understanding the Importance of Insurance and Managing Risk
An unexpected occurrence, such as a death, disability, or other personal loss, is certainly not the type of life event for which you can easily plan and often times it’s a topic that people choose to avoid thinking about altogether. “I’ll deal with this another day” they say to themselves. Yet the financial ramifications of this type of neglectful thinking can be staggering—not only for you, but for your family as well. Therefore, it is important to make a risk management plan part of your overall financial strategy.
Insurance, in all its varied forms, is simply a method for handling risk. In order to plan an effective insurance program, you need to consider the risks to which you and your family are exposed and how financial loss could affect you. For each risk exposure, the key elements to consider are the severity and frequency of loss.
All Risks Are Not Created Equal
In certain situations, insurance is required: For example, some states require a driver to obtain auto insurance in order to receive or maintain a license and some lending institutions will not approve a mortgage application if the potential owner does not also purchase homeowner’s insurance. While a base level of coverage may be required in these instances, you, as the insured, still may choose the amounts and levels of coverage purchased, according to your specific risk needs.
Some risks may be so negligible that you may decide to accept more responsibility for any potential loss. If you recently purchased a new cell phone you were probably asked if you wanted to buy insurance protection in the event you were to lose or break it. At that moment, you had to make a decision about the impact paying full price for a replacement phone might have on you and your family’s financial situation. While it might not be the highlight of your day to pay the $800 or so to replace the phone if you have emergency savings you should be able to cover the cost without much harm. In insurance language, this is called “self-insuring”. You self-insure for risks you choose to accept.
In contrast, in other situations, the risk is so large (or the cost of self-insurance so great) that the best strategy is to try to avoid the risk entirely. You practice risk avoidance in daily life when you decide something is “not worth the risk.” In addition to required coverage, you may customize insurance to protect against certain extras according to your needs. For example, it may be wise to purchase a policy rider for your homeowners policy if you own expensive jewelry or art that is worth more than the value provided by standard coverage.
Sometimes, risk can be reduced by taking extra measures to control the potential conditions that may lead to loss. For instance, when I recently bought a new iphone I decided to decline the insurance. Instead, I bought what I thought to be an extra secure phone case (military grade!) and a screen protector to reduce the chance that my phone would break when I inevitably do drop it. This is called “risk mitigation”. We practice this type of evaluation all the time in our day-to-day lives.
Risk Transfer and Risk Sharing
Buying insurance is the process of transferring risk you cannot afford, or choose not to accept. Since you may be unable to afford to rebuild your home and replace all of its contents in the event of fire, you may choose to transfer that risk to an insurer by purchasing the appropriate amount of homeowners insurance. However, even in situations of risk transfer, it is quite common to share some of the risk.
For example, the deductible on an automobile or homeowners insurance policy is a form of risk sharing—you accept responsibility for a small portion of the risk (deductible) while transferring the bulk of the risk to the insurer.
I encourage you, as part of the financial planning process, to take a closer look at the types of risks that you and your family face on a daily basis. Ask yourself the following: What is my risk level and how much of that risk can I afford to self-insure? What types of insurance, in addition to required coverage, might I need? And, how much coverage should I purchase? Assessing your ability to assume risks, the types of insurance needed and the amounts necessary to cover any gaps is not a one-time exercise. It’s likely that your answers to these questions will evolve as your life and financial position change.
The fundamental rationale behind all forms of insurance is the ability to determine which risks can be transferred on a cost-effective basis.