Now let’s take a look at tools to help mitigate certain financial risks.
“By failing to prepare, you are preparing to fail.”
However carefully you plan, life will sometimes throw you a curve ball resulting in large unexpected bills or expenses. Insurance is a financial product that can help protect you against many of these potential risks.
Key Concept:
Insurance
Insurance can be thought of as a “just-in-case” fund, that is, money that’s available to take care of unexpected circumstances. There are many kinds of insurance…
The common types of insurance
Home insurance can be used in case there is damage to your home, such as a fire, hail damage or a burglary. The insurance coverage will pay to fix the damage - or even replace your entire house and all its contents, if necessary.
Auto or Car insurance can be used in cases such as an accident, or if a tree branch falls on your car and you need to get the car repaired or replaced.
Health insurance is used to pay for medical expenses and covers cases like a broken arm, or if you need to get your appendix taken out. But it also covers more regular procedures like an annual check-up and for prescription drugs - or at least a portion of them.
As mentioned, most people have car insurance, home insurance, and health insurance. If you rent an apartment rather than owning your own home, you’ll typically get renter’s insurance. It covers your possessions but not the apartment itself (that’s for the landlord to deal with).
How insurance works
The way insurance works is that you pay an insurance company a monthly or annual fee, called a premium, and then they cover the charges if and when you need that protection.
Insurance policies typically have a deductible amount. That’s the amount you have to pay out of your own pocket before the insurance kicks in. The higher the deductible, the lower the monthly premium. If you have the ability to pay for smaller repairs or doctor bills when they come up, it can be a lot cheaper to select a high deductible resulting in a lower premium.
Insurance is sometimes required by law: you can’t drive a car in most states unless you are insured. Or it might be required by a company - banks won’t lend you money to buy a house unless you have insurance on your home.
In other cases insurance is optional. You aren’t actually required to have health insurance - and unfortunately, many people don’t because they can’t afford it - but if you don’t have it, most doctors won’t take you on as a patient.
Likewise, there is no requirement to have life insurance, but at certain stages in your adulthood, it’s a good idea to have some.
For things that are very valuable (such as a car or home) - or the expense is potentially very high (such as medical procedures) - insurance is a really important financial tool to allow you to get through life knowing that if something unexpected happens, that it won’t be financially devastating.
Life insurance
Some people have life insurance and others don’t. Life insurance isn’t really for you - it’s for people who depend on you. If you don’t have anyone who depends on your income, you don’t need it. But when you do get married or choose to live with someone, then life insurance can make sense.
There are two major types of life insurance:
Term life insurance covers you for a specific period of time, say 10 or 20 years. When you are young and healthy, the odds of something happening are low so term insurance is pretty cheap. For a 25-year-old in good health, a 20-year term policy for $1 million in coverage might be a few hundred dollars a year. People often get this when they start a family to protect against the loss of income if a person dies. But maybe in 20 or 30 years when your kids are older and out of the house, and you have money saved up, it’s not necessary, so you can just let the policy expire. 98% of term life insurance policies expire without payment.
Whole life insurance or permanent insurance is different. It’s a policy designed to last until you die and to provide money for your heirs. It’s often part of an estate plan. In contrast to term insurance, over 95% of whole-life policies are paid out, thus they are much more expensive, but they have some other features like a buildup of the cash value that can be withdrawn, as well as some tax benefits. Still, it’s not really necessary for most people and there’s common advice to “buy term insurance and invest the difference” which is going to be the right choice for most people.
Other types of insurance
There are a host of other types of insurance:
Disability insurance protects you if you are unable to work for an extended period of time. More than one in four of today’s 20-year-olds can expect to be out of work for a year or more before they retire, because of a disabling condition.
Disability insurance protects your income in these cases. You pay a premium to the insurance company and in the case you are unable to work, they pay a portion of your income (generally 60%).
There are short-term policies (they start after two weeks and last up to a year) and long-term policies (they start after a year and last until retirement). The short-term policies are a lot cheaper than the long-term ones but sometimes you can get an affordable long-term policy through your employer.
Disability insurance protects your income for yourself, in contrast to life insurance, which protects your income for others who depend on it.
Types of insurance you probably shouldn’t buy
There are other kinds of insurance like extended warranties on electronic products such as a TV, computer, or camera. Or travel insurance for certain costs of a planned trip, like airline tickets and hotels.
These types of insurance are often priced much higher than they should be given the likelihood of a problem occurring. You might pay 10% of the cost of a TV for an extended warranty that lasts for 3 years when the probability of something going wrong with the TV over that time is less than 1%.
Or these policies have so many exceptions that when you need them, they don’t pay off. Travel insurance doesn’t cover you if you just change your mind - it typically covers cancellations due to a death in the family, unexpected jury duty, or a job loss. Phone insurance won’t cover water damage, for example.
In these cases, and many others, just having an emergency savings fund can act as your “whatever else happens” insurance. This is sometimes called “self-insuring” - you will use your own money to pay for the repair, replacement, or loss on your own and forego the premium charges. The nice thing about an emergency fund is it can be used for anything.
We also talked about deductibles earlier - having an emergency fund frees you up to select higher deductibles on your insurance policies and save money on the premiums.