What is insurance for?

Most people think of insurance as protection against something bad happening. That’s not right. Insurance can’t prevent a loss from occurring. Rather, it protects you from the catastrophic financial consequences that would otherwise occur.

That distinction is important because not every loss requires insurance.

If you lose a pair of shoes, that’d be annoying, not catastrophic. You’d simply buy another pair. But if your house burns down, the financial consequences would be vastly different.

Insurance exists for that kind of risk – a financial loss you can’t afford.

Four Ways to Manage Risk

There are four ways to manage a financial risk. You can avoid it. You can accept it. You can reduce it. Or you can transfer it to someone else.

Consider your home. You could avoid the risk by not owning a home. You could accept the risk by owning one and doing nothing to protect it. You could reduce the risk by installing smoke detectors and fire extinguishers. Or you could transfer that risk to an insurance company.

Insurance is risk transfer.

This way of thinking is more useful than simply asking, “Do I need insurance?” The better question is, “What financial risks am I facing, and how should I manage them?”

Don’t Insure Every Risk

You don’t need to insure every financial risk you face. Trying to insure every possible loss defeats the purpose of insurance.

Ask yourself: If a loss occurred, could I afford it? If the answer is yes, you don’t need insurance for that loss. If you answer no, you need protection.

The question is not whether something could go wrong. (Something will always go wrong.) The question is whether the financial consequences would be significant enough to require financial protection.

If you can pay the loss without disrupting your financial plan, you can accept that risk yourself. If the loss would force you to use money you need for something else, go into debt or damage your financial security, transfer that risk through insurance.

Your Deductible Determines How Much Risk You Keep

Your deductible is another form of risk management. It is the amount of the loss you will pay; the insurance will pay the rest, up to the policy limit.

A higher deductible means less money out of the insurer’s pocket and more out of yours if a loss happens. Before you raise it, make sure you have that amount set aside in your cash reserves.

With a high deductible, you take on more of the loss – in exchange for a lower premium. When you choose a lower deductible, the insurance company takes on more of the risk and thus you pay more for the coverage.

The right deductible is one you can afford to pay when a loss occurs.

In other words, your deductible is not an insurance decision. It’s a financial planning decision.

Look at the Risk, Not the Policy

Insurance should be part of your financial plan, not a collection of policies you buy and forget.

Your circumstances change. Your assets change. Your liabilities change. Your ability to withstand a financial loss changes. Your insurance should change with them.

Buy a new car. Remodel your house. Get a dog. Add a teenage driver. Accumulate more assets. Each change can change your risks – and the amount of financial loss you could handle. Review your coverages often –at least once a year.

Your goal is to have the right amount of protection for the risks that could seriously damage your finances.

Don’t Buy Insurance on Price Alone

Price matters, but it isn’t the only factor.

A cheap policy means the insurer doesn’t expect to pay a claim. An expensive one means the opposite. So, the more a policy costs, the more you probably need it.

That’s why price alone tells you little. Know what the policy protects, what it excludes and how much it pays if you file a claim.

Don’t Buy More Insurance. Buy the Right Insurance.

Before you buy a policy, change one’s features or decide you no longer need it, start with the risk.

What could happen?

What would it cost you?

Could you afford it?

If yes, accept the risk.

If no, transfer it – to an insurance company.

Learn more: Explore PFI’s Insurance resources to see how each type of coverage fits into your plan.