The insurance industry has long been one of American’s least favorite industries. A YouGov poll from fall of 2002 of 39 industries showed insurance as the fourth lowest rated industry, below frequent punching bags like Oil and Gas and Pharmaceuticals.
And it’s not surprising the insurance industry isn’t popular. For most of us It’s an opaque industry where actuaries crunch tons of data and determine rates that are hard to understand. Insurance companies benefit from signing you up to plans that you use as little as possible and the world is rife with stories about insurance companies making it difficult to obtain benefits or denying people benefits that seem like they deserve. Insurance also rests on people’s fear of loss and so insurance retailers often target and exploit those fears in order to get folks to buy a policy.
And that’s not to mention the people in our industry of financial planning that get paid by insurance companies for selling insurance and so will advise clients to purchase unneeded and expensive insurance products (I’m looking at you Whole Life Insurance) that they then receive commission on.
(As an aside, that’s why I pride myself on being a Fee Only Advisor – I want my incentives to align directly with those of my clients and so I do not get paid on any sales commissions for any insurance or financial products).
But, at its core, insurance is an important and necessary part of a financial plan. Insurance is essentially a pooling of resources that allows a large number of people to spread the risk of an unlikely but severely financially damaging event among the whole pool of insured people. While it’s unlikely that my house is going to burn down, I’m happy to pay insurance on the off chance I do have a fire. And I’m okay if I never use that insurance but someone else in that pool uses it due to an unfortunate circumstance.
Of course, insurance companies aren’t free to run. They have to make enough to pay the bills and do the work and, in most cases, provide shareholder profits as well. What that means is that, on it’s face, most insurance is not a “good deal” for the consumer and it’s fair to be skeptical about insurance products.
The expected return of your insurance investment is always going to be less than what you are investing. Imagine insurance for a product that costs $90 to replace and that one in ten people will make a payable claim on the product. The insurer might charge $10 for insurance. If the chance of you needing that insurance is one out of 10, your expected return in $9 on an expense of $10, while the insurance company is making $1 per policy to cover overhead and make a profit.
For this reason, insurance should primarily be utilized for required purposes (think automobile and house) and for risks where the outcome is so costly that it could devastate you and your family’s future (think life, health, disability and long-term care insurance as well as auto and house). In those cases, you accept that you may not have a great return on the investment but the peace of mind that, even if the worst happens, you or your family will be financially okay is well worth it. And, in those cases, that “peace of mind” has a value even if you can’t put a specific price on it.
But like tipping, it sometimes seems like insurance has gotten out of control. You can buy insurance for event and plane tickets, additional insurance for rental cars, and insurance for all manner of home goods including most home electronics. In those cases, the insurance is almost definitely not worth it. Yes, replacing an expensive phone that you dropped might be a bummer or you might be disappointed that you got sick and were unable to use that ticket to Hawaii that you bought, but it’s important to realize that the expected return on insuring those purchases is lower than not insuring them. And, if the worst happens in those cases, they shouldn’t impact you or your family’s long-term financial health.
In general, your first reaction to purchasing insurance should be skepticism and the question you should ask yourself is: “if the worst were to happen, would we be financially devastated without insurance?” If the answer is “yes” then you should be looking to find the insurance coverage that best meets your needs.
Over the next few weeks, I’ll be publishing a series of articles digging into some of the most commonly asked questions about insurance.
