It's About Context...
I often cite studies, reports and other research when posting my blogs. One question that has come up is do these studies actually mean anything. It’s an excellent question.
Because of my innate curiosity, I’m always trying to poke holes in my logic and the research I’ve read over the years.
I’ve been lucky enough to spend a lot of time around some of the leading thinkers and brightest minds in financial planning as well as reading peer-reviewed articles and research. Naturally, this has led me to delve deeper into the data.
Back around 2009-10, I came across a quote from Ben Feldman, one of the most prolific salespeople in world history, who said:
"Doing something costs something. Doing nothing costs something. And, quite often, doing nothing costs a lot more!"
Last time we reviewed the most overlooked insurance and the limits and limitations of government benefits.
Now let me ask the question: What would you do?
How long would you be able to keep a roof over your head, the lights on and food on the table, if a disability kept you off the job?
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!