Unlike so many things in life that we use our hard-earned money to buy, insurance is one of the very few things that we pay for and actually hope to never use. So why do we buy it and why do we need it? Maybe we should start with the concept of insurance. In its most base form, insurance is the spreading of risk between multiple people, businesses, or groups to ensure that no insured party suffers a loss that they cannot afford. If your home was destroyed in a fire, could you afford to rebuild it without insurance? For most people, probably not. Similarly, if you were in a car accident, could you afford to replace your car? Maybe, but the true value of auto insurance is not in the replacement of your vehicle, or even someone else's, but in the $1,000,000+ of liability coverage it provides - that is a cost that many people cannot afford. In these two instances it is easy to understand how insurance works - home and automobile owners put money into a pot to ensure that if any one of them suffers a loss, it is covered by the whole group, not just the single individual. Home and auto are not the only insurance options in the marketplace, but they are good examples as every home or auto owner is required to hold some form of coverage.
What about optional insurance?
Well, it follows the same purpose, but not the same concept. In most cases of optional insurance, you are not insuring "real" property. Here are a few examples of optional insurances: liability, life, health, disability, boat, RV (excluding motor homes). The last two on this list are real property and are optional to ensure in Canada, but provide an interesting comparison. When it comes to insuring your boat or RV ("real" property), it is not difficult to determine the liability as it is usually the cost of the unit, but what about the first four items? In those circumstances you are insuring against a loss that cannot accurately be determined. Yes, there are tools to forecast your life and disability requirements based on your current income, debts, age, or in the case of liability, the project, but all of these factors will change as time goes on, also changing the possible loss. This is where the purpose of insurance remains the same, but the concept changes – you know there is a liability, but it is difficult to pinpoint what the liability will be.
How much do you need?
When you sign up for any insurance policy the amount of coverage you have is listed in the policy, but how did you get to this number? Is the purpose of life insurance to cover any debts you may be leaving behind, or to also compensate your family for the income you would have earned had you worked until retirement? And what if you did not pass away but suffered an injury or illness that made you unable to earn an income - how much and for how long do you need money actively coming in? What would the consequences be if you lost this ability? It all boils down to – what losses can you afford to suffer, and which ones can you not. The reason that most disability policies end at age 65 is the expectation that income insurance is no longer needed after this age. If there is little to no liability, then insurance is not required. If you can afford to never earn an income again, then disability insurance may not be appropriate for you. If you have no debt, a full education fund for your children, and a “nest egg” for your spouse to survive their remaining days, then life insurance may not be appropriate for you. (There are situations where insurance can be used as a financial planning tool to help ensure smooth transition to your heirs, but I will speak to that in another blog post.)
Is the true purpose of insurance to “spread risk”? To the insurance company, that is exactly what it is. But what is the true purpose of having an insurance policy for the insured? Is it the dictionary definition of insurance, or is it to ensure that there is a safety net there for you in case the unexpected happens? To ensure that you, your family, or your business does not suffer a loss that it cannot recover from? So when you ask yourself, “do I need insurance?” maybe the better question to start with is, “what can I not afford to lose?”