You may remember from the previous article How to Manage Personal Financial Risks that, as individuals, we face several types of financial risks, and we can take many actions to manage or reduce these risks. One of the more important tools we have available is transferring the risk to an insurance company. In this article and Part 2 we’ll take a more in depth look at the role of insurance in reducing risk.
What is the purpose of insurance
If some events occur, the financial loss we face could ruin us, or at least cause major damage to our personal finances. We protect ourselves from the impact of these events by purchasing insurance: this means we pay the insurance company (a monthly or annual premium) to assume the risk from us. If the unfortunate event occurs, we make a claim with the company, and depending on the amount of coverage bought, you can recover what you lost either partially or fully.
How does insurance work?
In simple terms, while everyone faces the same risk e.g. all drivers face the risk of a car accident (because any driver can get into an accident at any time), the likelihood is very low that everyone would get into an accident at the same time.
But all drivers wishing to protect themselves from the risk will pay a premium for the protection. The numerous small premiums paid will form a large pool of money, and when someone suffers a loss, money from the pool is used to compensate them. Put another way, funds from a large group of people are pooled to pay for the losses of a small group.
The “spreading” or “sharing” of risks among everyone who contributed to the pool is the reason why insurance is sometimes described as the “pooling of risks”.
When a pool is large enough, insurance companies can predict with reasonable accuracy (using past experience and statistical techniques) the amounts they are likely to pay in claims. This is referred to as the law of large numbers.
Types of risks you can insure
There is an almost endless list of risks that can be insured, but for our purposes, we are focusing on personal financial risks. These mainly include:
- Loss of income or life
- Losses to personal property
- Losses from personal liability
Types of insurance
As mentioned above, insurance can cover numerous risks, and in many ways, it is restrictive to try to consider “types” of insurance; it’s better to consider what risks you face (as an individual or even a business) and consult an insurance company to understand what policies exist to cover the risk.
Having said this, from a personal risk management perspective, we can use two broad categories to focus our discussion:
- Life and protection insurance
- General insurance
It may be useful to think of this category of insurance as long-term insurance because the risks being protected could take several years to crystallize, if they actually do. As a result, policies could be in force (i.e. active) for many years, and continued coverage requires a long-term commitment from the purchaser, with typically monthly premium payments.
It is worth noting that while many people refer to this type of insurance as simply “life insurance”, this is sometimes confusing because you can purchase a life insurance policy (which pays out on your death) separate from other protection policies. So, just be aware that life insurance can have a more general meaning (a range of products for risks that exist throughout your life) or a narrower meaning (a specific type of policy).
General insurance is a catch-all description that covers a range of non-life coverage against losses and damages. It is also referred to as property and casualty insurance.
General insurance is sometimes referred to as short-term insurance because in many cases the coverage period for most policies is usually one year, with premiums normally paid once a year. (Note there are exceptions to this structure, but they are less frequent in Caribbean markets.)
Insure or self-insure?
Before we begin to look at the two categories of insurance in more detail, let us consider when we should “self-insure” versus insuring with a third party. Note, it is recommended that you should always consult an insurance professional as part of this process.
The reality is, not all risks need to be insured. When you decide against buying insurance to protect against a particular risk, you are actually deciding to self-insure that risk i.e. you accept the financial consequences if the event occurs.
In the article Cari$ Rules for Financial Freedom we outlined the basic approach to deciding what to insure. Answer three questions:
- Firstly, what should you insure? The answer is you should insure what you cannot afford to replace (and of course, what is required by law e.g. car insurance).
- Secondly, how much risk are you willing to accept? This requires a common sense approach to balance how much you can afford with what risk you want to insure. Covering all risks could be expensive, so try to list the risks you face in order of importance, and then decide which ones you actually need to cover.
- Thirdly, how much should you insure, meaning what is the right amount of coverage? Again, the simple approach is do not think about “making money” from insurance (which is impossible, by the way); make the coverage the minimum amount you need to cover the risk.
To expand on the above, once you identify the potential risks you face, for each risk ask yourself:
- What is the severity of loss if the event occurs i.e. how much would it cost you
- How frequent is the event likely to occur
Put simply, if the loss would not affect your standard of living, then there is no need to buy insurance. Where losses could significantly damage your finances, these should be insured.
More specifically, low-frequency, high-severity risks are best managed by purchasing insurance protection, because even though the loss could be infrequent, the impact is so significant that you are unable to absorb it personally. High severity, high frequency losses would be prohibitively expensive to insure (assuming an insurance company is even willing to accept the risk). These risks must simply be avoided where possible.
In summary, deciding what to insure is really a process of understanding what the loss would cost you, compared against your willingness to pay to get rid of the risk.
As you can see, insurance plays a major role in providing financial peace of mind. In Part 2 we’ll look more specifically at the types of insurance protection available for the financial risks we face.
We hope you enjoyed reading this article, and we’d love to hear from you in the comments below if you have questions or experiences to share!