How much should you insure for?|
|Insurance is a bet you are most likely to lose. The insured pays a premium to the insurer (the insurance company) in return for the insurer promising to pay an agreed amount to the insured if a specified event occurs. The process of the insurance company considering the risk and evaluating the risk is called ‘underwriting’, after which the pricing is arrived at by the ‘actuaries’. The price so arrived at is called ‘premia’ – which is a risk transfer fee.
The probabilities are that the specified event will not occur.
And the premium is calculated to be sufficient to pay out to those insured who do suffer the event, cover the insurer’s administration and selling costs, and then leave a profit for the insurer. Most of the insureds will end up paying more in premiums than they will receive back as benefits. That is, most of the insureds will lose the bet. And I guess we are all happy losing this bet!
So some balance is needed when considering insurance. The advisors tend to be salesmen who talk up the need for insurance and the sums that should be insured. It is not uncommon for people to be over-insured, an unnecessary expenditure for them. The key steps when evaluating any insurance proposal are:
(i)Identify the risk
Ask yourself what event you wish to be insured against? It could be theft, illness, disablement, death, malpractice suit, etc.
What is the probability of that event occurring? The probability of illness is far greater than death, hence a critical illness insurance that covers, say, 20 diseases will cost much more than a pure death (or life!) insurance
(iii) Calculate loss
Ask what are the economic consequences of the insured event occurring? The cost of losing a mobile is negligible whereas the cost of a dentist’s chair breaking down is much higher and critical.
(iv) Determine cost of insurance
Ask what is the proposed cost of insuring against that risk and those consequences.
(v) Weigh costs and benefits
Now decide if the cost is worth the benefit. This is the most difficult part. Most people do not realize they are talking of the risk of their family being on the roads when they are not around. Hence they think the premium being asked for is high. Only when you know the cost of ‘not having’ something can you compare it with the cost of ‘having’ it.
A competent financial planner will guide you through these key steps as part of your financial planning process. This requires a consideration of many subjective factors and attitudes. But it all gets down to risk management: understanding risk and being comfortable with it.
Indeed a financial planner has to consider risk management when preparing a financial plan for a person. This is so even if the person has asked the planner not to: the plan should on its face contain a statement that risk management advice has been declined.
This is because a financial planner can be negligent and in breach of contract if they fail to advise on insurances.