At a glance:
The purpose of insurance
The role of risk in insurance
Summary of insurance
Managing financial risk is important to successful financial planning.
Financial risk comes in many forms — and is sometimes not recognizable as financial risk. Sure, the first thing one thinks about regarding financial risk is losing money on an investment.
But financial risk goes way beyond that. If an injury causes you to lose income, that is financial risk. If you lose a lawsuit and have monetary damages against you, that is financial risk. If a family "breadwinner" dies or becomes disabled, that is financial risk. Anything "unexpected" that has an adverse effect on your financial goals is financial risk.
How you manage risk is a financial planning concern of major importance. For hundreds of years, people have used insurance as a means to help manage financial risk. You need to consider financial risk and the ways to handle it and how to avoid financial disaster.
The purpose of insurance
We live in a world full of risk. Risk is the possibility of loss. Sometimes the loss is trivial, while other times it causes major personal and financial hardship. There is no way to completely eliminate all risk, but there are ways to avoid, minimize, or protect oneself from risk. When risk is low, or the cost is not too high, one can assume risk. When it is too costly to assume risk, we need other ways to manage it.
Some history, first
Insurance was invented to help merchants minimize financial losses from shipwrecks when moving goods across the ocean in sailing ships. It works on a mathematical principle based on "the law of large numbers."
Shippers noticed that while some merchandise was lost due to shipwrecks, not all ships were lost. If all shippers anted money into a pool to cover the losses of the shippers whose merchandise was lost, then they all had a fair chance of not being wiped out, if disaster befell them.
Odds-makers were able to compute the probability of losses to determine how much each shipper needed to pay in order to cover the probable losses, based on the cost of each shipment. Of course, the odds-makers and investors would receive compensation for their services, and they factored that into the premiums, too.
The role of risk
Modern insurance works in the same way. Regardless of the risk, one can determine the mathematical probability of it occurring and the financial risk at stake. Anyone who owns an automobile knows that he or she is required to have automobile insurance to cover the risk of damage to someone else's property.
With many years of statistics on automobile damage costs, insurers are able to determine the amount of premium necessary to provide benefits to insure automobile owners. Using the same principles, one can buy insurance to minimize financial loss due to accident, natural disaster, legal liability, illness, disability, and even death.
Insurance is a tool used to help manage financial risk. Financial risk can take many forms. There are risks to our investments, liabilities for our actions, and risks to our ability to earn income. There is insurance to manage all these risks. We encourage you to read articles on specific types of insurance to get in-depth coverage of each specific kind.
Special forms of insurance are available to cover almost any other financial risks. For example, there is unemployment insurance, investment insurance, and dismemberment insurance (for loss of a body part). Some high-fashion models are even insured against loss of income due to loss of their good looks.
Premiums for such insurance are also based upon the likelihood of an event occurring and the amount of benefits to be paid.
The role of risk in insurance
Over many centuries, the purpose of insurance has remained the same: to provide financial relief due to catastrophic losses. Money from many people is pooled to pay for losses incurred by a few.
There are other ways to handle risk: Avoiding it
Insurance is not the only means of managing risk. One way is to avoid risk. Risk avoidance can lower the financial cost of risk. That is why insurance premiums are lower for persons and businesses that take measures to lower risk.
For example, automobile insurance premiums are lower for drivers with good driving records (no accidents and no cited violations of driving laws), and non-smokers pay lower medical insurance and life insurance premiums than do smokers. But it is not always possible to avoid risk, and sometimes, insurance premiums may be too costly.
Another way to manage risk is to share it with others. Some insurance policies allow you to share the risk in order to get a lower premium. If you can assume a certain amount of financial risk, then the insurance premium on the balance of the risk will be lower.
For example, some automobile policies have lower premiums if you take responsibility for the first $500 of liability — known as a deductible. Medical insurance premiums can also be lowered if you have higher deductibles or co-payments.
Finally, for those who cannot tolerate any financial risk, risk can be transferred to someone else, usually the insurance company, who assumes full responsibility for financial risk. Of course, this method of risk management has the highest premium cost.
Types of insurance
Property and casualty insurance defined
Investments in real property and hard assets are at risk for theft or destruction by natural causes, accident, or mischief (generally, acts of war and terrorism are not covered by property and casualty insurance). Property and casualty insurance helps manage these risks. Property and casualty insurance is available in the form of home insurance, automobile insurance, boat insurance, business property insurance, etc.
It protects specific assets from many forms of loss and insures the property owner against liability for damages resulting from the asset's use. The cost of property and casualty insurance is based upon the value of the insured assets and the environment in which the assets are located.
For example, auto insurance rates vary depending on the area in which the automobile is located. Communities with high rates of auto theft and accidents will have higher auto insurance rates. Auto insurance also takes driving records and the insured's age into consideration when pricing policies. Some of the types of auto insurance coverage include liability, medical payments coverage (or personal injury protection), comprehensive physical damage, and uninsured/underinsured motorists' collision.
Errors and omissions, professional malpractice insurance, professional liability insurance
Many occupations and professions risk causing damage to others that can result in financial awards against them. If one were sued for malpractice, this would cause financial hardship when one had to liquidate assets or assign future income to pay the awards.
Doctors, lawyers, accountants, financial advisors, construction workers, and anyone else whose occupation can inadvertently cause harm to others or others' property may be liable for financial damages. Financial damages, whether paid from assets, future income, or both, can be daunting and pose a severe financial hardship. There is specific insurance that helps manage these risks arising from one's occupation. Premiums for such insurance are based upon industry statistics and the history of the insured person.
Sometimes claims against a person may not be made for years after the occurrence of the action causing the claim, so it is important to know the conditions under which the policy will cover claims.
We all know people who have high medical care costs. Often paid by employer contributions, healthcare insurance is essential to assure an adequate level of medical care. Yet, there are many Americans who have inadequate or no health care insurance at all.
There are many forms of health care insurance programs available, including fee-for-services plans, hospital and medical service plans, and managed care plans (prepaid health plans that provide comprehensive health to members, health maintenance organizations, preferred provider organizations, exclusive provider organizations, and point-of-service plans). Premiums are based upon group statistics and levels of care provided.
Long-term care insurance
With the aging of America, there is a strong need for long-term care insurance to cover costs of nursing homes and assisted living care for the elderly. For eligible individuals, federal Medicare and state-sponsored Medicaid insurance help defray the high cost of medical care.
Life and disability insurance
If a family were to lose its income due to the death or disability of the principal earners, it would face financial hardship. While no one can put a monetary value on human life, one can put a value on his or her earning ability. Life insurance and disability insurance pay benefits to replace lost earnings due to death or disability. The premiums for this insurance are based upon statistics for the age, health, and occupation of the insured, as well as the amount of benefits to be paid.
While both life and disability insurance are available through groups, such as employer plans, individuals can buy policies tailored to their specific needs. Life insurance is so versatile that many individuals use it for advanced financial planning purposes, such as retirement planning and savings, as well as for death benefits.
How to shop for insurance
Buying insurance should be no different from making any other major purchase, such as a car or house. Before making the purchase, you should determine what features you really need.
This is important to assure that you get what you expect at a reasonable cost.
What to think about
Insurance is a risk management tool. You should first determine what risk you are managing.
Also, determine how much of the risk you can assume yourself, in order to keep insurance premiums low. For example, if you bought a house and have a substantial mortgage, you might want to insure the value of the house against loss due to fire, flood, or other catastrophic events since you would be responsible for the mortgage balance even if the house were destroyed.
On the other hand, if you bought a jalopy car for a few hundred dollars cash, it might not make sense to insure it against loss, because its value is so low. With tangible assets, it is easy to see the relationship, but with intangibles, it is difficult, but not impossible.
If your gross family income were $50,000 per year and you wanted to insure against the risk of loss due to a disability, for example, you would need to determine how much of that income was at risk.
Only the income from work is at risk for loss due to disability. After deducting taxes, the net income at risk is only $32,000. This might be the amount of disability insurance to purchase. In shopping for insurance, first determine what you are insuring against and how much insurance you need.
Next, look at the insurance companies
Find the insurance companies that have the kind of insurance you need. Not all insurance companies insure all risks. You will need to find the right insurance companies for the kinds of risks you are insuring against. Some insurance companies handle more than one line of insurance, but they are usually related lines.
Property and casualty insurance companies usually provide automobile, homeowner/renter, and personal liability lines of insurance. Life insurance companies usually provide life, accident, and disability insurance. Many agencies try to provide "one stop shopping" by offering several different kinds of insurance; however, you may find it more economical to shop for insurance from companies that specialize in one or two lines only.
You may need to find an insurance agent who understands your specific needs and who can direct you to the insurance provider that is best for you. You can purchase insurance directly from some companies, but you need to do your homework first. What you save in commissions may be spent in your time and effort.
Some insurance is available only to groups, such as employee groups, unions, professional associations, or religious or fraternal organizations.
What to compare
Compare features, benefits, and premiums. The cost of insurance is more complex than the premium alone. When shopping for insurance, be sure to read the fine print. An insurance policy is a legal contract. The language is exact and definitions are very important. If you do not understand the language, have a trusted advisor explain it to you. When comparing two policies, do not let price be the overriding factor.
A more expensive policy may not be better (or worse) than a less expensive one. Some policies may provide different benefits or risk coverage riders (benefits). Be sure the policy you buy provides all the coverage you want and need. Save money by avoiding policy riders you do not want or need.
Most states require insurers and their agents to provide you with an "insurance buyer's guide." Ask for one and read it carefully.
Summary of insurance
There are many types of insurance to help you manage financial risk, from loss of property to loss of income. Some insurance helps provide cash flow when income and savings are insufficient. You now have a general knowledge of insurance as a risk management tool.
This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.
Read more information and tips in our Insurance section