Insurance is an important part of a person’s finances, and yet it is not the be-all-end-all answer that insurance agents and self-styled “financial consultants” would have you believe. After covering the necessary, an extra buck spent on insurance is another dollar that could have gone towards your retirement instead. But what is necessary? Here is an approach that I hope would help you approach your next insurance purchase better, or aid in the review of your existing policies.
It’s all about financial risk management
As non-billionaires, we face many types of financial risk in our lives. They can be broadly classified in four categories as below:
Low probability and low impact events
We have events that may happen that are unlikely to happen, and the financial impact isn’t devastating if it does happen. An example of this would be losing or breaking your mobile phone.
Personally, I’ve never done this before (knocks on wood), but if it does happen, the financial impact isn’t particularly devastating. It’d sting, but I am not financially ruined if I had to buy another phone, use an older phone I have lying around, or continue using the phone, broken screen and all. We retain such a risk, even as there are insurance plans that cover for such events. It’s called self-insurance, and it’s just this wonderful thing where your resources and savings absorb relatively puny financial impacts.
I used to buy AppleCare for all my iPhones – and it was an annual upgrade affair – up until the iPhone 4s where I decided that it just wasn’t really worth it. The accumulated cost of buying insurance for your phone might just be more than it costs to replace your phone, if you were clumsy once a decade or so.
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High probability and low impact events
You may be a bit more careless with your personal belongings, and arguably the probability of breaking your phone is a lot higher. Now what? Buy a phone case or something.
Another example that falls in this category would be falling sick and needing to see a general practitioner. It happens often enough, I suppose, about twice a year probably, and there are indeed insurance policies that cover for this, but you may quickly dismiss the idea after comparing the cost versus potential claims you might possibly make in a year.
We try our best to reduce such risks, and ultimately retain them.
Low probability and high impact events
The third category of risks is where insurance comes in handy. There are events we may encounter that are quite unlikely to happen, but creates an enormous financial impact if they do happen. Typical terms like “critical illness” and “disability” pop up here, and these are indeed risks we transfer by purchasing insurance.
Actually, such risks are transferred even if we do not buy insurance. When you incur large hospitalisation bills that you are not insured for, your family are beset with the bills. If you don’t insure your premature death and such an event happens, your young dependents lose their source of income. I think we’d rather transfer such risks by purchasing insurance.
High probability and high impact events
The last category contains stuff like working as a skydiving instructor or something. Thankfully, we don’t really face many such risks where bad things are likely to happen, and the financial impact is huge if they do occur.
Most, I imagine, would belong to hazardous recreational sports, or more dangerous occupations like firefighters. Insurance tends to be pricey for such risks, if any insurer even wants to provide such coverage. Such risks I can think of are optional, and we try to avoid these risks if we can.
So how do we evaluate the necessity of a particular insurance policy or coverage? Most people go by the premium amount, as well as the likelihood of coverage. I implore you to consider the financial impact of such events as well. If it’s huge and something that is potentially financially devastating, there is little choice for the working person aside from insurance. If not, consider other means to manage the risks, such as self-insuring instead.
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