Simple Money: A No-Nonsense Guide to Personal Finance - Tim Maurer (2016)

Part IV. PLANNING FOR THE UNEXPECTED

Avoid, reduce, and assume the risk you can handle, and transfer the risk that you can’t with insurance.

Chapter 14. INSURANCE: WARNING!

WHY do I need to read this chapter?

You’ll want to read this short chapter before buying any type of insurance because insurance products aren’t the only way to manage risk. In fact, purchasing insurance—while entirely appropriate in many circumstances—should be the last resort in any risk-management strategy because it’s the most expensive way to handle risk in the majority of cases.

Let’s take just a few minutes to walk through the other three ways we can manage risk and then discuss how insurance actually works.

How to Manage Risk

There are four ways to manage any risk we might face. The first way is to eliminate the risk completely. John Madden, the famed football coach and commentator, was deathly afraid of flying. So he took the Madden Cruiser—a swanky bus—to all those Monday Night Football games, even if they were cross-country trips. Of course, we know that flying is actually safer than driving, but we can’t argue that Madden didn’t successfully eliminate the risks associated with flying by simply not flying.

Next is a risk-management technique we use constantly, often without even noticing. It’s risk reduction. We set an alarm clock to reduce the risk of being late to work. We wear a helmet to reduce the risk of being injured in a bike accident. We reduce the risk of overexposure to the sun by wearing sunscreen.

Third, we may assume risk, a risk-management technique perfected especially by teenage boys and young men. This is often the default risk-management decision for many, but don’t doubt that it is a decision. When we enjoy the bliss of swimming in the ocean, we’re assuming risks ranging from strong currents, wayward waves, jellyfish stings, and a one in 3,748,0671 chance of a nibble from a shark.

The last way we manage risk is to transfer all or some of it to another party. When you hand someone your car keys, you’re transferring risk. And any time you buy insurance, you do the same thing. You can insure just about anything you fear—from the loss of an iconic mustache2 to the hazards associated with an asteroid impact. For this reason, it’s imperative to understand that just because an insurance policy exists doesn’t mean you should purchase it.

Eliminate. Reduce. Assume. Then, and only then, transfer risk.

A basic understanding of how insurance companies operate helps us understand why every risk shouldn’t be transferred, and why it’s foolish not to transfer others.

How Insurance Works

Insurance companies are in the pool-making business. Simply put, they take a group of people who share a common risk, but spread that risk across the entire collective or pool. Consider the example of an early life insurance “policy”:

A primary occupation in colonial New England was commercial fishing. Recognizing the associated dangers, local churches would take up a collection each time sailors would go off to sea. In the event that one did not return, his family would receive the financial boost. The community shared in the risk.

The money we pay into an insurance policy—or an insurance pool—is called a premium. The money that exits the pool to compensate those who suffer a loss is called a claim. The organizer of the pool—the insurance company—receives the difference between the two, the profit. Therefore, the insurance company has an inherent conflict of interest. They prefer not to pay claims.

If you’re struggling to know whether a risk should be eliminated, reduced, assumed, or transferred, consider the Simple Money risk-management technique:

1. Eliminate risks that offer little reward.

2. Reduce risks by employing common sense.

3. Assume risks that you can endure.

4. Insure catastrophic risks.

Contemplate this risk-management strategy in the light of the simple act of driving home from work:

1. Research suggests that texting while driving is six times more dangerous3 than drunk driving. Most of us have done it at some point, but statistics such as these, and the stories of needless deaths, clearly indicate that the minuscule benefit to be gained from checking our email or sending a text in the 20 minutes it takes to commute home is simply not worth the risk. This is an easy one to eliminate completely.

2. Any time we step into a car, we know there’s a risk of being involved in an automobile accident. But there are many decisions we can make to reduce the risk of that activity—most notably, wearing a seatbelt. After nearly losing my life in a car accident in which I did not wear a seatbelt (chap. 4), I’ll never need to think twice about reducing this risk again.

3. Many of our insurance policies have a risk assumption feature built into them. It’s called a deductible. That’s the amount we’re expected to pay out-of-pocket before the insurance kicks in. In the case of our driving-home-from-work scenario, most auto insurance agents recommend low deductibles—$50, $150, or $250. Of course, if we had a $500 claim—perhaps even a $1,000 fender bender—we’re not likely to claim it through our insurance for fear of a lifetime of higher premiums. So, why pay for insurance that we don’t want or plan to use when the alternative is a higher deductible that would lower our premiums?

4. The type of risk we should be happy to transfer is risk we simply couldn’t assume ourselves. You can buy a new phone if you drop yours in the kitchen sink, but if you have an accident on the way home from work—and it’s your fault, and the person you hurt sues you, and they win and are awarded a million bucks—chances are high that you couldn’t write that check. This particular type of risk can be transferred through a combination of your automobile insurance and your “umbrella” liability insurance—two types of coverage we’ll discuss more in chapter 18.

The Simple Money risk-management method can be used effectively for every risk decision we make, from hitting the snooze button in the morning to shielding our families from the catastrophic financial risk associated with a tragic death—which happens to be the topic of our next chapter.

1. There are four ways to manage risk—it can be eliminated, reduced, assumed, or transferred through the purchase of insurance. The last resort in any risk-management strategy should be the purchase of insurance, because it’s the most expensive way to deal with risk.

2. Premiums are paid into insurance “pools,” and claims are paid from those pools to people who suffer the risk they’ve insured against. The difference between the two is the insurance company’s profit.

3. The Simple Money risk-management method:

· Eliminate risks that offer little reward.

· Reduce risks by employing common sense.

· Assume risks that you can endure.

· Insure catastrophic risks.