Wednesday, January 04, 2006

Risk Assumption & Insurance

As we go through life, we are faced with many risks of loss... your house burning down, a premature death, losing an engagement ring, your stereo breaking before you expected it and so on. The frequency of these events can be measured by insurance companies and you can buy insurance to recoup the costs of each of these events.

When a financial planner works with you to plan your insurance purchases, they may tell you that you shouldn't buy some types of insurance such as: children's life insurance, extended warranties for consumer electronics, or disease-specific coverage (eg. cancer insurance). What they are really telling you is that you can afford to assume the risk of some perils. In other words:

You should only buy insurance for potential losses you cannot afford.

To explain, let's look at a few examples:
  • Life Insurance for a Child - beyond the fact that I find the whole idea quite distasteful, a child's death is rarely a financial burden on the family. It's certainly one of the worst things that can happen to a family... it's not, however, a financial risk
  • Extended Warranties - this is one of the best money-making products that retailers sell and it's almost always a bad deal for consumers. If you can't afford the loss of your new TV breaking two years from now, you probably shouldn't be buying it.
  • Engagement Ring Insurance Riders - you need to understand the replacement value of your ring as compared to your net worth. My wife's ring could be replaced for less than 1% of my net worth. Would it suck to have to replace it? Absolutely. Would it hurt our finances? Not materially.

The ring example adds one additional dimension to the risk assumption statement above:

You should only buy insurance for potential losses you cannot afford or don't want to afford.

If the thought of financing your own risk of loss makes you worry and adds stress to your life, you should consider purchasing insurance coverage for those emotional perils.


At 10:38 PM, Anonymous Jonathan said...

I agree with your rule about only insuring against losses that would really cause true financial pain.

At 12:46 AM, Anonymous personal finance advice said...

The Carnival of Debt Reduction #17 is now live. Thank you for your contribution!

At 1:15 PM, Anonymous PENNY STOCK INVESTMENTS said...

Insurance is sometimes a scam.


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