Insurance offers you the ability to protect against the downside risk of many things in life (even death itself). But, is insurance really worth it?
Of course, the answer is, as always: it depends.
But before we can understand when insurance is a good idea, and when it’s best to say no, we need to look at what insurance is.
What is Insurance? And how does it work?
Insurance is a promise to pay you if a certain event takes place.
The event in many insurance policies is the replacement of a product in case it breaks (device insurance). But it could be covering damages caused, for instance, by a driving incident (car insurance). Or even paying your estate funds in the event of your death (life insurance).
Selling these “guarantees” is a business. A very lucrative business.
And the skyrocketing corporate profits means one thing: you, the consumer, loses out far more often than you win.
Most of the time that’s a good thing. It’s far better to pay for life insurance and not die. Or car insurance and not crash. But, with insurance offered on a wide range of products that we use in our daily life, buying too much insurance can be a poor financial decision. Spending money on things you don’t need is a poor purchase, no matter how you look at it.
When Should You Buy Insurance?
Insurance is often made more complicated than it needs to be. Deciding when to buy, and when to pass on insurance, needs to follow a simple formula.
“What you are insuring needs to be of sufficient value to put you in a bad financial position without the insurance.”
What this means is, if what you are insuring would be difficult to replace with your current financial resources, the insurance is probably a good idea. Or put even more simply:
Emergency fund < Value of Item = Buy Insurance
If your emergency fund is sufficient to cover the loss, you shouldn’t buy the insurance. Instead, keep increasing your emergency fund as well as your other investments.
If on the other hand the value of what you are buying is more than your emergency fund, then insurance is a good idea.
Insurance is often offered on a variety of purchases. I’ve had offers for insurance from anything as small as a video game, to cell phones, all the way up to my automobile and home.
Most recently, when shopping for new appliances, I faced the sales pressure from the appliance salesperson. I was being regaled with tales of broken appliances that weren’t covered by warranty, and frightened by the estimated cost of repair visits. But quickly looking at the numbers, I could tell I wasn’t going to come out a winner. Insurance on the kitchen appliances was coming out to more than 10% of the total cost of all the appliances. Do I buy? Do I pick and choose? If so, which appliance is most likely to break?
Ultimately, I fell back on the formula: my emergency fund could cover the replacement cost of any single appliance. And the likelihood of all appliances breaking at the same time must be extremely rare. Rather than buy the insurance, I’ll be better off passing on the insurance, and setting a little extra away into my emergency fund.
Further Use of the Insurance Formula
Of course, sometimes insurance is more than a simple yes/no question. In the case of home and auto insurance especially, there are different policies. One of the key factors in determining the cost of the policy is the deductible, or the amount you need to pay first before insurance pays out. As you can imagine, the higher the deductible (the more you need to pay first), the lower the insurance rates.
The formula we looked at above can be modified slightly.
Emergency fund > Difference in Deductible = Buy High Deductible Insurance
In this case, if you can cover the difference in deductible without jeopardizing your financial position, you should buy the higher deductible insurance. This will mean you pay more in the event of a claim, but if you don’t need to make a claim, your insurance rates are lower.
Common auto insurance deductibles are $0, $500, and $1,000. If you can cover the $1,000 deductible, the difference in insurance rates from a $0-deductible insurance policy could be thousands of dollars over the course of your life.
Never fall prey to sleazy sales tactics again, you have the numbers to support you in making the right choices. That simple formula telling you what you can afford in an emergency, and what you should seek external protection on, will help cut a lot of confusion out of the insurance question.
Making sure you are adequately covered is a function of what financial risk you can comfortably absorb personally. When you can look out for your own financial interests, you need to rely less on insurance to cover the difference. And spending less on unnecessary insurance helps you get even further ahead.
The freedom to pick and choose what is right for you without worrying about repercussions is liberating. That is one piece of financial freedom.