Friday, July 6, 2007

Help with Understanding Your Insurance Needs

One thing I've noticed is that insurance decisions are often made on an emotional basis, or on the spur of the moment with minimal analysis, and the decisions sometimes defy logic. As a result, it may be useful to at least work through the basics outside of the pressure of a salesman and in a strategic, rather than adhoc, basis.

Let's start with the fact that there are a huge number of potential types and sources of insurance available, each with a salesman trumpeting its benefits. Obviously, if you are not careful, you could insure yourself into the poorhouse.

So, how should you identify those you must have, versus those it would be nice to have? Start with the premise that you must insure yourself against a financial catastrophe, but not against events that might be painful, but not catastrophic. That is the basis for buying medical insurance and for buying liability insurance. A reasonably likely event such as a major illness or accident could be catastrophic to all but the most financially secure without these insurances. The same applies to flood, fire and casualty insurance on your home. And, for those with minimal financial reserves who have families including young children, term life and disability insurance is mandatory. Death or disability could financially handicap the family for many years.

Beyond these basics, the case for insurance becomes more murky. It would, of course, be painful if you wrecked your car and had to replace it yourself, but would it be catastrophic? Would failure of your washing machine be catastrophic enough to pay for the insurance of an extended warranty? I know it would be nice if these things were insured, but keep in mind there is an offsetting cost. Remember that, under the best of circumstances, the insurance company must base their rates on the likelihood and cost of the insured event, as well as a profit for themselves, commissions for the salesman plus allowances for the less careful and for possible fraud, all on top of their administrative costs. Would the insured event be catastrophic enough to justify these costs? Would your death be financially catastrophic if you are single are newly married? What about if you are near retirement? Note the emphasis on financial-of course it would be catastrophic emotionally, but insurance will do little to help with that. I'd suggest that life insurance should be reduced as the family gains more financial independence and nears retirement.

What about deductibles? Generally, high deductibles considerably reduce insurance cost. Why? Because most events are small and the administrative cost for small claims is high, while the difficulty of preventing fraud or unjustified claims also climbs. At the same time, deductibles which are higher than the usual may fall well below a level that would be catastrophic for you. Because of this, my strategy is to buy deductibles which are just below the catastrophic level for insurances I must have. The cost of the insurance covering the difference between low and high deductibles may be some of the most expensive insurance you can buy. For example, in looking at my medical insurance, I discovered that the cost of medical insurance with a $200/year deductible is about $4000/year. The cost of a similar policy with a deductible of $4000/yr is less than $1000/yr. So, in effect, it cost me $3000/year to insure against the possibility of spending an additional $800/year out of pocket, should I have over $4000 medical cost in a given year.

Let's talk about when and where you should buy your insurance. Buy insurance only after you have created a strategic plan for all your insurances, thinking logically about what events would be catastrohic for you. Then, talk to several companies, comparing rates, coverages and the stability/reliability of the company. Avoid buying coverage adhoc or on the spur of the moment, especially if packaged with another product. These make if difficult to assess the risk or identify what are often outrageous rates or large fees.

As an example, whole life combines insurance with investments. Unfortunately the investment is often subject to large fees and commissions or low returns hidden in the policy. In another personal example, I had an auto salesman try to insert (without even mentioning it) life insurance that would pay off the balance of my auto loan in case of my death. Once I discovered it, he launched into an emotional plea in favor of my wife and kids, who he thought might have trouble paying off the loan if something happened to me. I advised I already had adequate life insurance and, on checking found that the cost of the insurance from my normal insurer would have been less than half what the dealer would charge, and would have been for the full balance of the loan, rather than the declining balance covered by the dealer. Extended warranty insurance is fraught with the same issues, and is even more difficult to evaluate.

I could go on and on, but you can take it from here. Just remember the basics:
  • Develop an insurance strategy in a calm time and logical manner. This allows you to quickly dismiss offers which do not fit your strategy.
  • Insure against only those events that would be catastrophic for yourself or your family. The administative cost, fees and profits involved are too high to justify insuring other events.
  • Get competitive quotes for the insurance you need.
  • Do not combine insurance with other products.

With these simple steps, you can save yourself thousands of dollars in unnecessary cost, and at the same time be comfortable that you have the insurance you need.

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