31 Days to Financial Independence (Day 26): Considering Insurance

“31 Days to Financial Independence” is an ongoing series that appears every Thursday on The Simple Dollar. You might want to start this series from the beginning!

Last time, we finished up our examination of investing and saving for specific goals with a broader look at saving for smaller goals, such as a car or a house down payment. Today, we’re going to move on to look at insurance.

Insurance is a challenging issue. Many people often buy insurance policies, not because they need them, but because they think they’re supposed to or because it’s sold to them by an effective insurance salesman.

Here’s the number one thing to remember about insurance: The only purpose of insurance is to protect something you already have. That should be your sole goal in purchasing any insurance policy. It’s not very good as an investment tool. It’s not a wise use of your money if you’re protecting something you don’t have yet or if you’re protecting something that doesn’t really need protection.

Thus, the absolute first thing you should be asking yourself regarding insurance is what do I stand to financially lose if something really goes wrong in my life? (We’re not talking about emotional losses here.)

Let’s say your spouse died. Would you be able to financially survive without that person, especially over the next few years?

Let’s say you died. Are there people who are dependent on you that would struggle?

What if you got into an accident and totaled your car? Could you afford to get a car back on the road quickly without insurance?

What if you got sick? Could you pay your medical bills with your current health insurance package? (You almost assuredly do have health insurance because of current federal law; the question is what kind of insurance you have.)

What if your house burned down? What if your apartment was robbed? How do you handle these disastrous situations?

Some people might be in situations where they have little to protect. If someone robbed their apartment, the only thing worth taking might be an old television. If they totaled their car, it was a rust-bucket anyway.

Others may have enough money in the bank to handle certain emergencies. For example, although we do have policies, my family could probably survive at this point without life insurance policies if either Sarah or I passed away early.

Most of us, though, find ourselves in a situation where we do have things to protect but we don’t have enough other assets to easily handle a major disaster involving those things that we wish to protect. That’s where insurance comes in.

Insurance is basically protection. You pay a certain amount each month so that if one of those disastrous situations occurs, the insurance company will step in and help. It takes a large scale worry about the future and effectively makes it disappear.

To summarize: Don’t buy an insurance policy without a specific purpose, and that purpose should be to protect something you have against a threat you cannot handle. That is the reason for insurance, nothing more.

Also, here are a few quick terms you should know. A premium is the amount you pay regularly to the insurance company to keep the policy. A deductible is the portion of an expense that you might turn into the insurance company that you are responsible for before the insurance company begins to pay out. A beneficiary is the person who receives the benefits of a life insurance policy. Straightforward stuff, but I want to make sure we’re all on the same page!

Here are some specific tips about figuring out what insurance might be right for you.

Exercise #26 – Evaluating Insurance Options

This is not going to be a thorough coverage of every kind of insurance; that would take a book to cover. Instead, I’m simply going to provide an overview of several common types of insurance that cover the most common threats that people face, and start with a few general tips for all types of insurance.

General Tips

First of all, do your own homework. Don’t assume you need a policy because some salesman or some guy on the internet told you that you did. If you’re considering buying a policy of any kind, read up on it. Know what the policy is about and what it covers. Most of all, understand why you are buying it – and just saying that the salesperson told you that you needed it is not enough, nor is simply listing the reasons the salesperson gave you.

Shop around when you’re buying a policy. Don’t just buy whatever policy that the guy you know from church is selling or that you heard about on the radio. Figure out on your own whether you actually need such a policy and, if you do, get quotes from lots of different insurers.

In general, higher deductibles save you money over the long run, but only if you have enough money on hand to cover that deductible. High deductibles are a good money-saving tactic, but they’re only good if you have plenty of money in your emergency fund and you’re not making constant claims on your insurance (if you are, your premiums are going to go up anyway).

You should also make sure that your policy comes from a well-regarded insurance company. Do your homework on the company itself and make sure that it’s highly rated. The best place to check is with your state insurance regulators. Start by looking up your state’s department of insurance website and find the companies you’re considering. See how they compare to each other. You might also want to check out the insurance company comparison tools at insure.com.

Let’s move on to some policy-specific strategies. Some of these overlap with these general tips, but they’re re-emphasized because they apply especially well to that specific insurance type.

Life Insurance

The sole purpose of life insurance is to provide for people left behind after the insured person dies. This usually means spouses who might be relying on the deceased person’s income to keep the bills paid, dependent children, or other dependent individuals.

Given that, if you do not have people dependent on your income, you really don’t have much reason to get a life insurance policy. There are almost always going to be better uses for your money.

Life insurance really only becomes a factor when you’re in a situation where someone is truly dependent upon your continued income, at least in the short term future. In those situations, a policy that can effectively replace your income for a number of years is in order because it will allow those people who depend on you to have a stable life until they are ready to move on into their own personal life choices – i.e., your children grow up or your partner finds a better career or remarries.

The best route here is to seek out a term life insurance policy. It’s the least expensive option and solves the exact problem described above. Determining the benefit size of the policy isn’t an exact science, but ensuring that your children won’t struggle to grow up and that your spouse has at least a year or two to get back on his or her own feet are good benchmarks for figuring out how much to save.

There are many calculators out there for life insurance policies in terms of figuring out how large your policy will be, but they all tend to be authored by insurance companies or are based on insurance company models, so they end up recommending a larger benefit than is really necessary. Why? Life insurance companies don’t sell policies unless they believe that, on average, they’re going to make money, so if they’re selling you a policy, they want it to be a big one, because that will raise the premiums you pay each month.

What about things like whole life insurance or universal insurance? They’re generally not worth it. They’re far more expensive than term policies and the other financial benefits generally don’t have any significant value for many, many years. The truth is that when you’re older and have reached retirement age, the only insurance you’ll probably want is enough to cover your funeral expenses so you’re not a burden to your family, and if you’re wealthy, you may not even want that, so such a lifelong policy isn’t useful.

What about life insurance for children? Again, ask yourself what happens to your finances if that child passes on. Would you be able to pay for funeral expenses easily? If yes, then there’s little need for insurance.

A final note: don’t make life insurance choices for your kids. Many parents want to buy a whole life policy for their kids when they’re very young. The reality is that many children don’t end up taking over that policy at all and it just goes away when the parents stop paying it at some point. Let your child make their own life insurance decisions, especially since (in general) you won’t be financially affected by their passing. Consider only a term policy if you think you might be expected to pay for funeral expenses and couldn’t afford them, and keep it small.

Health Insurance

This is a subject that’s changing rapidly, so it’s hard to give specific advice on health insurance. Right now, there is a federal mandate that you have some form of health insurance. Will that still be true in a year? Maybe, maybe not. Right now, there is a state marketplace in which you can buy health insurance. Will that still be true in a year? Maybe, maybe not.

I will say this, however: You’ll save a ton of money on health insurance if you build up some personal savings and hold onto it. Think of that money as an extended emergency fund.

Why will that save you money? It’s simple – if you have a healthy amount of cash in the bank, you can get away with a policy with a higher deductible, which means a lower premium that you have to pay.

My fundamental advice when it comes to health insurance (and this will be repeated with other kinds of insurance) is to spend less than you earn, get rid of debts, and then start saving it. As you build up savings, you’ll be able to make choices like raising your deductible on many types of insurance that you hold, which will lower your monthly premiums, which makes the gap between your spending and saving even bigger.

If you’re struggling to come up with enough money to cover the deductible on a health care expense, that’s a sign you need to take a serious examination of your financial state and career path.

Homeowners Insurance

The biggest trick with homeowners insurance is that the default policy does not cover everything that you might think that it will. In many areas, you need special insurance to cover things like earthquakes, floods, tornadoes (in some areas), hurricanes (in some areas), war, nuclear hazards, and other things. You’ll want to know all of the exclusions on your policy and assess for yourself whether those exclusions make sense for you and, if not, add extra insurance to cover those exclusions.

Many people think they’re covered in the event of a major disaster, only to find out that they aren’t covered like they think they are. Don’t get caught in that trap. Be proactive and contact your insurance company and find out what their list of exclusions are on your policy and what you need to do to be covered.

Another thing to know is the difference between “actual cash value” and “replacement cost.” This refers to how much your homeowners insurance will pay you for your belongings in the event of a disaster. “Actual cash value” refers to the value of all of your stuff after depreciation. Remember, when you buy things and use them, they go down in value; “actual cash value” pays what you would get for them if you tried to sell them used. “Replacement cost,” on the other hand, is what it would cost to replace that item with a new version of the item.

Think of it in terms of your refrigerator. If you were to sell it in a yard sale or on Craigslist, you’d probably get only a fraction of what you paid for it – that fraction is the “actual cash value.” On the other hand, the price if you bought a new one is the “replacement cost.”

Unsurprisingly, “replacement cost” is going to cost you more in the policy than “actual cash value.” As noted above, the one you should choose depends a lot on your own personal savings. If you have enough money to replace a lot of the things in your home, then “actual cash value” is fine; without adequate savings, “replacement cost” is what you’re looking for.

Another thing worth noting: Most homeowners insurance policies have lower premiums if you take basic actions to improve the security and safety of your home. Taking steps like installing fire alarms and home security devices typically pay for themselves over the course of a few years due to the reductions in premiums. Talk to your insurance provider about steps you can take to reduce your premiums and then decide whether they’re cost-effective for you. Chances are that if you intend to live in the house for more than a year or two, they’ll be cost-effective.

Renters Insurance

Renters insurance is a policy that is often recommended for people who are renting their property. It simply covers the possessions inside of the rented property.

As with homeowners insurance, there tends to be a lot of variation in terms of what the policy covers, with more robust coverage costing more. For example, many policies require extra coverage to protect you against water backup that might damage your property. Some may require extra coverage to cover you in case of liability against the property you’re living in (say, for example, you do something unintentionally to damage the apartment or the apartment building).

With renters insurance, one thing to consider is whether the possessions in the apartment have enough value to be worth covering. In my first apartment, virtually everything in there was bought secondhand and was pretty beat up. In all honesty, I would have actually been happy if someone had taken that awful couch out of there, and the TV, too. If you have very little value, your insurance should either cost pennies or isn’t worth it at all.

The one element to consider is liability insurance, even if you don’t have many possessions. Read your lease carefully and see how it assigns liability in the case of accidental damage. If it’s unclear, ask the landlord about liability in the event of a fire or some other disaster. Most leases don’t mention such liability or assign it by default to the tenant. Apartment fire liability for the tenant is a very real danger, so if you’re liable, even if you don’t have many possessions, a small liability policy would make sense, as you likely can’t afford the cost of an apartment building fire.

Auto Insurance

As with many other types of insurance, there are often state laws which require minimal levels of auto insurance if you own a car. Usually, just liability insurance is required – it pays for the damage to other vehicles and property if you’re in an accident, but not your own. Comprehensive coverage offers protection for you against damage to your own car as well.

Also, as with other types of insurance, the type of policy you want centers around your situation. If you’re driving an old beater and you can afford to get another beater in the event of an accident, it doesn’t make any sense to carry anything more than liability insurance. On the other hand, if you’re driving a brand new car and can’t easily afford to pay off that car in a jiffy and get a new one, then you need comprehensive coverage (and it won’t be cheap).

Next time, we’re going to start wrapping up the series by looking at a few specific issues. We’ll start by looking at how to handle a crisis when you’re turning things around financially.

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