It's About Context...
In Rebar to Cement Your Financial Foundation, the following table showed your future potential earning power until age 65 at various ages and income levels. It’s a lot of power!
In personal finance insurance is perhaps the most difficult subject to address because it forces us to think about the unknown. In particular, our own mortality and sense of invincibility. Bad things happen to other people—not me.
Further, because insurance is about protecting against a future unknown, it’s difficult to determine or calculate how much protection you and your family will actually need. Then there’s the issue of estimating how long will you need the protection. What is known is that you will pay premiums month after month and year after year. What is unknown and uncertain is whether the event you’re insuring against will ever occur.
For example, you pay your auto insurance premiums month after month and year after year. Let’s assume your average annual auto insurance premium is $1000 and that you’ve paid it diligently for the last 20 years and never made a claim. That’s $20,000 of auto insurance premiums gone.
What could you have done with that $20,000? You could have done all sort of things with that money—invested it toward your retirement, added it to your rainy day fund, spent it on a nice vacation or two, used it to fund college, and the list goes on.
On one hand, you may perceive it as a waste of financial resources.
But, on the other hand, what if you have to make a claim for a serious accident—where you are considered at fault: One that involved totaling your car and that of another driver. Add in some medical expenses and then a little compensation for pain and suffering.
A rule of thumb for pain and suffering is about 1-5 times or more the cost of medical bills and lost income.1 The settlement for major accidents could be worth $50,000-$100,000.2 (In California, the compensatory median award for personal injury trials is $150,000—and many of them are auto related).3
In our example above, you’ve paid $20,000 in premiums, and your insurance company settled your claim for $100,000. Your policy provided five times more in benefits than you paid in premiums. In other words, you paid $0.20 on the dollar for the benefit your policy paid.
Would you consider yourself lucky for paying pennies on the dollar for an event that could be financially catastrophic?
Now to the question that comes up frequently: How much insurance is the right amount of insurance?
My approach towards insurance is that the right amount should protect against catastrophic events.
Please note that others may disagree with this and that’s okay. There is no one absolute right way to determine the amount of insurance that’s right for you. Certified Financial Planner™ professionals and insurance pros can run various calculations and each has validity.
The real work (or art, if you will) comes in balancing a client’s tolerance for risk, financial capacity for handling and managing risk, their financial goals and cash flow.
Together these factors help determine the level of risk someone should retain versus paying the premiums. With high policy deductible limits you can lower your premium payments. With lower deductibles, you pay higher premiums.
Let me caution you that whatever you do, it’s dangerous to look at insurance as just another expense the way too many people do. It’s also dangerous to settle for purchasing the minimum coverage amounts.
I believe insurance (when chosen appropriately) is a reasonably priced hedge against unknown events that could potentially bankrupt you. In a lot of ways insurance is nothing more than purchasing financial peace of mind.
Here’s to yours!
In Part 1 of Why Are Social Security Investment Returns So Low?, we looked at how insurance companies work and why they are inherently conservative. Let’s continue by examining Social Security and its investment returns.
Now about those Social Security Investment Returns
In the previous blog Social Security: What is it? Insurance or Investment?, we determined that Social Security from its beginning was and is an insurance program that blends the personal needs of each participant with the collective needs of society.
Given that it operates like private insurance, the logical question is: “How does an insurance company work?”
In this two part blog, we will first answer that question. In part two, we will look at Social Security investment returns.
For over two decades, we’ve heard ongoing calls to transform Social Security from a government administered “group” program, where everyone who’s ever worked benefits, to an investment program of individual accounts, where you as the investor manage your own account.
You hear the arguments about how the stock returns have far outpaced those of U.S. treasuries and how an individual could be worth so much more. That may be true, but I assume there’s far more to it than your potentially receiving higher returns.