Forget what you know, or what you think you know, about insurance. Ignore what you've heard from insurance agents and put aside your biases. I'm going to tell you the truth about insurance and its proper role in a financial plan.
No matter what you've been told, no matter what you think, there is one purpose — and only one purpose — for insurance: To protect against a financial loss. The key word is financial, for insurance does not protect against losses themselves.
As a financial advisor, I can't protect you from suffering a loss, but I can help you to avoid from suffering financially as a result of incurring a loss. For example, I can't prevent you from getting in a car accident, but I can help you avoid losing money as a result of it.
Thus, insurance protects you from the adverse economic impact caused by a loss. If there is no financial loss, there is no need to protect against it financially.
Have you insured your shoes? I'll bet not, because if you lose them, you'll just buy another pair. You don't need to insure your shoes because losing them would not present a significant financial loss.
But your house is another matter. Losing that certainly would constitute a major financial loss. That means you’ve got to figure out a way to manage the risk that you might lose your house. And that's just one risk you face; as you'll see, there are many others as well. Financial professionals often refer to insurance, therefore, as risk management.
Four Ways to Manage Risk
Financial losses can occur when you die; are injured; become sick; if your property is damaged, destroyed, or stolen; or if you get sued. You must protect yourself financially in case any of these events occur. In other words, you must manage these risks, and there are four ways to do so.
To illustrate, say you need to get a package across town, but you fear the dangers of highway traffic. You could:
- Avoid risk. Refuse to drive. But then the package does not get delivered.
- Accept risk. Driving a car is dangerous, but you accept the risk in order to deliver your package.
- Reduce risk. Drive carefully and wear a seatbelt.
- Transfer risk. Have someone else deliver the package for you.
To apply these four management techniques against, say, the financial consequences of having your house burn down, you can:
- Refuse to buy a house in the first place (risk avoidance).
- Buy the house and ignore the problem or hope it never happens (risk acceptance).
- Install smoke detectors and fire extinguishers throughout the home to help you to discover and extinguish the flames before major damage occurs (risk reduction).
- Force someone else to pay for the loss if the fire occurs (risk transference).
The last strategy is what insurance is all about.
Originally published in The Truth About Money