What is Insurance, What Kinds of Insurance are There and Why is Insurance a Critical Part of Managing Your Finances?

“Are you OK? I heard there was a tornado in Los Angeles.”

“Are you and the family safe? We saw pictures of the tornado on the news.”

I received a number of calls and emails this week asking the same question. We live in Los Angeles, a place that’s generally safe from tornadoes, but the unexpected happened last week with a freak tornado. Thankfully, despite causing damage to some structures and uprooting trees, the tornado did not cause loss of life and lead to very limited injuries.

So, what does this have to do with my focus on helping people build financial acumen? The takeaway is that unexpected and bad things happen in life and any prudent financial plan needs to have risk management to mitigate their impact. The last thing you need if something unexpected happens to you is to worry about your finances while dealing with the other consequences of that event. That’s why there’s insurance, which is a critical part of prudently managing one’s finances.

What is insurance? How does it work?

Wikipedia has a simple and good definition of insurance:

Insurance is a means of protection from financial loss in which, in exchange for a fee, a party agrees to compensate another party in the event of a certain loss, damage, or injury. It is a form of risk management, primarily used to hedge against the risk of a contingent or uncertain loss.

The way that insurance works is that you enter into a contractual agreement called a policy with an insurance company to protect (insure) you from a specific risk. You make periodic, small payments called premiums to the insurance company as your side of the agreement. In return, the insurance company promises to make payments to you in the case that the risk you’ve insured against materializes. For example, you insure your house with a home-insurance policy. In the unfortunate event that it burns down, the insurance company pays you the amount of money which your policy stipulates to fund repairing or replacing your home.

Insurance plays a critical role of spreading risk across the population. The idea is that a large number of people pay small amounts for insurance. Only a few people end up actually needing to get paid for the unforeseen event so the premium funds those fewer large payments. Those who pay the premiums get the benefit of being covered in case of a large loss, which has a meaningful psychological value and are financially protected in case of the unforeseen occurring.

The premium you pay is determined by the amount of coverage that you buy and a number of risk factors that the insurance company evaluates using their actuarial and underwriting experience. In the home insurance example above, variables such as: What is the risk of a fire where your home is located? What materials is your home built from and how susceptible are they to fire? or What are historical crime rates. Ideally, the premium is set at a level which covers the insurance company for expected value of the payout they will make on your policy plus a sufficient additional amount to cover the insurance company’s costs and earn an economic profit.

Why should you buy insurance?

There are three main reasons that I recommend buying insurance:

• Protect you and your family from catastrophic financial loss: Unforeseen events can be very expensive. As a simple example, getting sick and needing surgery. A number of major surgeries in the US can cost well over $100,000 (Spinal fusion, Heart bypass and Heart valve replacement costs in 2021 >$100,000 as shown by Statista). If you don’t have medical insurance to cover such costs, you will need to pay out-of-pocket and very few people have an extra $100,000+ lying around. The key here is that low probability events does not mean no probability events. If one of those rare, unforeseen events does occur, insurance helps protect your finances from catastrophe
• Provide the proverbial “ability to sleep well at night”: The psychological benefit alone of knowing you have a safety net is worth a lot of money — I definitely sleep a lot better knowing there is a fallback for me and the people to whom I am responsible in case one of these bad events happen
• Meet legal or other requirements: Some insurances are legally required. For example, in a number of US states, car insurance is a requirement in order for you to be allowed to drive. Similarly, home insurance is a requirement many banks place on you before they are willing to extend a mortgage. If you don’t have the requisite insurance, you can’t access the product or service that you need

What are the major types of insurance?

There is a relatively small subset of insurances which one definitely should buy. For today’s post, I’m just going to provide a very top-line summary of these insurances. In the coming weeks, I will write posts tied to each of these specific types in case you want to dive deeper into any of them. Here’s what I consider important for everyone to buy:

• Medical insurance: In a world where the number one cause of US bankruptcies (~62% of bankruptcies as cited in The Balance) is medical issues, having health insurance is a must. Most people get medical insurance through their employer but there are ways to buy health insurance directly
• Auto insurance: Most states in the US require auto insurance with a typical minimum requirement of property and liability coverage. Each state is different so make sure that you get the details of what is required in your location and ensure that you have at least the minimum legal requirement. The penalty for driving without insurance can be significant so going without this insurance if you drive is not a risk worth taking
• Home or renter’s insurance: Home insurance is “a form of property insurance that covers losses and damages to an individual’s residence, along with furnishings and other assets in the home. Homeowners insurance also provides liability coverage against accidents in the home or on the property.” (Investopedia). These policies provide you a financial safety net in case of events as such your home catching on fire or being burgled. If you don’t own your home, you can get a renter’s insurance policy which covers your assets
• Business insurance: If you are a business owner, you should have insurance to protect your business. You probably also have legal requirements of insurance depending on the type of businesses or requirements from clients/customers who need proof of that insurance before they will place their business with you. The specific details of which kind and how much insurance you need will depend on your business

Beyond the insurance types that I mentioned above, there are a plethora of other types of insurances that you can buy and which may or may not be relevant to you. Here is just a simple bullet point list of some of the additional types of insurances you can buy. I’m sure that there are many more that I haven’t heard of, but I just wanted to give you a flavor of what might be available:

• Pet insurance
• Mortgage insurance
• Earthquake insurance
• Flood insurance
• Professional liability insurances for service businesses
• Surety bonds

This completes today’s post on insurance. The practical steps you can start taking from today’s post are:

• Audit your insurances: Every year or when you have a change in life circumstance such as getting married or having a child, review which insurances you have
• Map your insurance to each person or entity to whom you are responsible: Ensure that your insurances tie to any people or entities for whom you are responsible. For example, if you own a car, you need auto insurance or you need to have medical insurance for your family. If there is a entity or person for whom you are responsible who doesn’t have any insurance tied to them, there is very likely a hole that you need to fill
• Ensure that you have all legally-required insurances to at least the minimum required levels where you live

Thank you for joining me on my journey to build financial literacy for young adults and their families. Please share any comments or questions that you have in the comments section. If you are interested in reading more of my posts, please access my author page (https://vocal.media/authors/sudhir-sahay) where you can see all the posts I’ve published. Also, if there are any topics you’re interested in my broaching in future posts, please let me know. In addition to the comments section, I can be reached at [email protected].