Insurance: How much is enough?

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“You can never buy too much insurance.” I’ve heard it before, and I think this is a common way of thinking. More insurance means more protection, so it seems to be worth paying more. However, being over-insured means you’re throwing away money on protection you don’t need. To what extent should we be insuring our cars, our health, and our lives?

What is insurance?

Insurance is defined as “coverage by contract in which one party agrees to indemnify or reimburse another for loss that occurs under the terms of the contract.” The terms of the contract typically include a monthly payment (premium) from the insured person to the person guaranteeing the reimbursement. For example, one may insure their car by paying a monthly premium of $75. The insurance company may then pay for any damages on the car above and beyond $500. The $500 responsible by the insured is called the deductible.

How much insurance do I NEED?

This is the most difficult decision when buying insurance. If you don’t buy enough, you’ll be under financial risk if the incident does occur (for example, if you are in a car accident). If you buy too much insurance, you will be overpaying for what you really need. So how much is enough and how much is too much?

Insurance is a tool to eliminate financial risk on some possible occurrence. The occurrence is not 100% likely to happen nor is it impossible. The outcome is unknown. Insurance is used to protect against this unknown.

A good rule of thumb is to use insurance to protect yourself against an occurrence that would be financially catastrophic. For example, if you were at fault in a car accident that sent four people to the hospital, would you be able to take on $50,000 in medical bills? To many, this would set them back financially for many years. This is a risk that is unlikely but, if occurred, would be financially catastrophic for many of us.  This is Auto Liability Insurance.

Other examples of catastrophic occurrences that can be covered by insurance include a fire burning down your house (homeowner’s insurance), loss of income due to a death in the family (life Insurance), at fault in a car accident with medical bills (auto liability insurance), or a sudden medical condition arises and hospitalization is needed (health insurance).

How much more insurance do I need TO FEEL COMFORTABLE?

The section above covers the primary reason for insurance, which is to protect yourself against an unlikely but possible occurrence that would cause huge financial distress. Many people also use insurance to protect themselves against occurrences that may simply harm their bank account. To an extent, this can be good.

I renewed my car insurance in January, and I debated extensively about how much coverage I needed and how much I wanted. I knew I needed liability coverage because I cannot afford to pay $50,000 in medical bills. However, I debated whether I wanted comprehensive insurance. Comprehensive insurance covers damages to the automobile which aren’t from a collision with another car, including fire, theft, flood, etc. Also, if you were to back into a telephone pole or to hit a deer, comprehensive insurance would cover this.

My car is worth somewhere around $8,500. I decided that I am not willing to take on that risk. One deer running out in the road, although not probable, could cause an immediate $8,500 impact. Insuring against this risk puts my mind at ease so I can drive peacefully at night. Because it is unlikely, I decided on the high deductible of $1,000 to pay less in premiums. In other words, I am willing to take on the risk of $1,000 and pay the monthly premium.

The overuse of insurance

When I was in college, I once had a friend buy a video game for me at Best Buy (yes, I used to be a video game nerd and I’m proud of it). The game was Call of Duty, and the price was $60. He came back and told me that I owe him $70 for the game plus tax plus the protection plan. THE PROTECTION PLAN?? I was shocked. With all of the video games I had owned, I never once mishandled the game enough to where it wasn’t functioning. The probability is very low. And if something were to happen to the game making it unplayable, would I mourn for a week and then bury it in the backyard? NO! I would be fine. I’d get through it. I’d probably hold off on the next game I wanted to buy. The point is that losing the game would not be catastrophic and would hardly be uncomfortable.

There is a reason why insurance companies like Progressive and Liberty Mutual Insurance can earn so much in corporate profit, $902 million and $829 million in 2012, respectively. Insurance companies have statisticians using huge amounts of data to decide how much you will probably cost the company. They then tack on a certain percentage to cover their administrative costs like salaries and marketing. Finally, they add a bit extra to give themselves a profit. With good reason, statisticians make a lot of money (but they may end up with Statistician’s Blues).

So for anything non-catastrophic that won’t keep you up at night, why don’t we just self-insure?

Self-Insurance

Self-insurance is acting as the insurer and the insuree. Rather than paying the insurance premium to someone else, set aside the money on a monthly basis in a separate bank account. Online savings banks like INGdirect (now Capital One 360) make it easy to set up sub-accounts for this purpose. Rather than pay $5 for the extra protection plan on your video game, set that $5 aside.

Here is a way to make self-insurance work in your favor. The protection plan on a new basic iPad is $80 a year at Best Buy. Rather than buy the protection plan, put the $80 each year into a new account. Use it on repairs if needed. If there is $400 in your bank account in five years, you’re set to buy a new iPad (or iWatch or iHusband/iWife or whatever is new in 2018). Win-Win.

There is no doubt that insurance is a necessary tool to mitigate risk. The tough part is deciding what needs to be insured from an outside source, how much coverage do you need, and what can be self-insured.

How are you using insurance? What stories do you have where you were extremely happy to be insured? Do you regret anything about insurance you’ve had or didn’t have?

 

Image courtesy of David Castillo Dominici / FreeDigitalPhotos.net

About Trent

I started Frugal Purpose to share my love of personal finance to assist your pursuit of a more fulfilling life. I am a financial analyst by trade, traveler at heart, and want to share with you the beauty of this world.

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