Insurance:  Why It’s important and some considerations

By Bob Peters || May 1, 2023

Insurance is an expense that needs to be in your budget

Insurance is a way of protecting yourself and your loved ones from financial losses due to unexpected events. There are many types of insurance that individuals would purchase, depending on their needs and preferences. In this blog post, I will discuss some of the most common types of insurance and how you might think through a decision on key factors that affect coverage, premiums and deductibles.

Purchasing insurance is a new category of “expense” that needs to be included in your budget as you become financially independent.  When you were living with your parents, the insurance expenses were generally covered by your parents’ various insurance policies.  Insurance companies, unlike cell phone carriers, will not allow your parents to continue to provide coverage to adult children beyond a certain age.

Purchasing Insurance can help keep you out of a deep financial debt hole

Purchasing insurance allows you to avoid large catastrophic financial expenses.  Paying for insurance might be akin to spending money to change the oil in your car so to avoid a very expensive engine repair or paying to have a roof replaced to avoid water damage.  You might be tempted to skip on insurance if you are running a tight budget, but I would strongly advise otherwise.  Skipping on appropriate insurance can lead to finding yourself in a deep financial debt hole.

Premiums, Deductibles and Co-Pays

Regardless of what type of insurance you purchase you will pay a regularly recurring premium.  The premiums associated with insurance that may be provided through your employer like medical, dental, life, disability might be deducted from your paycheck.  Generally, the higher premium you pay the lower your self-insurance risk.

Self-Insurance and why it’s important to understand

What is self-insured risk? It’s basically the amount of money you are willing to pay out of your own pocket in case of a claim. For example, if you have a car insurance policy with a $500 deductible, that means you are self-insuring for $500. If you have an accident and the repair costs $2,000, you will pay $500 and the insurance company will pay $1,500.

Why does self-insured risk affect your premiums? Because the more risk you take on yourself, the less risk the insurance company has to cover. This means they can charge you lower premiums because they expect to pay less in claims. On the other hand, if you choose a lower deductible or no deductible at all, you are transferring more risk to the insurance company, which means they will charge you higher premiums because they expect to pay more in claims.

Which Option is better?

Let me give you an example that shows how the cost of insurance premiums can increase or decrease based on the amount of self-insured risk you are willing to take. Suppose you have two options for a home insurance policy: Option A has a $1,000 deductible and costs $800 per year in premiums. Option B has a $5,000 deductible and costs $500 per year in premiums.

Which option is better for you? It depends on how likely you think it is that you will have a claim and how much it will cost. If you think it is very unlikely that you will have a claim or that it will be very cheap, then Option B might be better for you because you will save $300 per year in premiums. However, if you think it is very likely that you will have a claim or that it will be very expensive, then Option A might be better for you because you will pay less out of your own pocket in case of a claim.

Of course, there is no way to predict exactly what will happen in the future, so you have to weigh the pros and cons of each option and decide what level of risk you are comfortable with. The more self-insured risk you are willing to take, the lower your premiums will be, but the higher your potential losses will be. The less self-insured risk you are willing to take, the higher your premiums will be, but the lower your potential losses will be.

Note to self:  If you do not have a healthy emergency reserve account and/or do not have income that substantially exceeds your monthly obligations you should probably minimize the risk of incurring a large out of pocket deductible.

Life Insurance

Life insurance is a type of insurance that pays out a sum of money to your beneficiaries (such as your spouse, children or other relatives) in the event of your death. The main reason to purchase life insurance is to provide financial security for your dependents and cover any debts or expenses that you may leave behind that become obligations of your spouse. Life insurance can also be used as a savings or investment tool, as some policies accumulate cash value over time.  The “friction costs” associated these universal or permanent life insurance policies, where there is a cash value or investment option, often make these unattractive as compared to term insurance.

As mentioned above there are two main types of life insurance: term and universal/permanent. Term life insurance provides coverage for a specified period of time (such as 10, 20 or 30 years) and pays out only if you die within that term. Term life insurance is usually cheaper than permanent life insurance, but it does not have any cash value. Permanent life insurance provides coverage for your entire life and pays out whenever you die. Permanent life insurance also has a cash value component that you can borrow against or withdraw from.

Here is the way I have thought about Life Insurance

Here is the way I have thought about life insurance.  When I’m single and do not have any dependents (a spouse or children) depending on my future ability to earn income then I do not need life insurance.  When I am retired and no longer earn a paycheck but can live off of my accumulated wealth and social security, I don’t need life insurance.  The years that I do believe it makes sense to have life insurance are the middle years when I have dependents that would need to maintain their lifestyle in the absence of my paycheck.  I strongly suggest if you are in the sweet spot of needing life insurance consider a term policy.  My opinion:  Do your investments via low cost, diversified ETF’s and generally avoid the path of universal/permanent where there is often increased complexity and higher friction costs.  Your situation is unique so I would encourage you to seek out expert advice.

There may be some situations where universal life insurance serves a purpose for long term estate planning for wealthy folks, but this is not relevant for the target audience of this blog, in my opinion.

Medical Insurance

Medical insurance is a type of insurance that covers some or all of the costs of medical care and services that you may need due to illness or injury. The main reason to purchase medical insurance is to protect yourself from the high costs of health care and avoid financial hardship or bankruptcy in case of a serious medical condition or emergency.

There are many types of medical insurance plans available in the market, such as:

– Employer-sponsored plans: These are plans that are offered by your employer as part of your benefits package. They usually cover a portion of your premiums and offer a network of providers that you can choose from.  If you have access to an employer sponsored plan, I will highly encourage you to take a look…the subsidy often provided by your employer can be very attractive.  You may also have the option to enroll in a flexible spending account (FSA) or a health savings account (HSA) to save money for medical expenses on a pre-tax basis.  The FSA and HSA accounts give you tax benefits which can be very attractive but that is a topic for another day.

– Individual plans: These are plans that you purchase on your own from an insurance company or through a marketplace (such as Apple Health or HealthCare.gov). They may offer more choices and flexibility than employer-sponsored plans, but they may also be more expensive or have less coverage. You may qualify for subsidies or tax credits to help you pay for your premiums depending on your income level and household size.

– Government-sponsored plans: These are plans that are funded by the federal or state government and provide coverage for certain groups of people who meet certain eligibility criteria (such as age, income, disability or citizenship status). Some examples are Medicare, Medicaid, CHIP and VA health care.

When deciding on the type and level of medical insurance to purchase, you should consider several factors, such as:

– Your health status and history

– Your expected health care needs and utilization

– Your budget and affordability

– Your doctors and location of facilities

– Your benefits and coverage options

– Your deductibles, copayments and coinsurance

A general rule of thumb is to purchase enough medical insurance to cover most of the costs of the health care services that you may need in a year, while keeping your out-of-pocket expenses as low as possible. However, this may vary depending on your individual situation and preferences. You should compare different plans and features carefully and choose the one that best suits your needs and goals.

What is this Co-Pay thing?

Co-Pays are generally found in medical insurance policies and is paid by you for services.  You might pay a $30 copay for each doctor appointment.  You might be subject to copays for prescription medications.  In addition to the regular premium you would pay for all insurance products and any out-of-pocket deductible costs, you will need to budget for co-pay expenses associated with medical care and prescription drugs.

Disability Insurance

Disability insurance is a type of insurance that replaces a portion of your income if you become unable to work due to an illness or injury that lasts for a long period of time (usually longer than three months). The main reason to purchase disability insurance is to maintain your standard of living and cover your essential expenses if you lose your earning capacity.  If you have access to disability insurance, I encourage you to take a look.  If you depend upon a paycheck to cover your living expenses, getting disability insurance can be the difference between going bankrupt and the ability to weather an extended health event that prevents you from earning a living.  An emergency reserve account can be spent quickly if you are unable to work for an extended period of time.

Short Term and Long-Term Disability Insurance

There are two main types of disability insurance: short term and long term. Here’s how they differ and why you might need both.

Short term disability insurance (STD) covers you for a short period of time, usually between three and six months. It kicks in after a waiting period of a few days or weeks, depending on your policy. STD is designed to help you cover your basic expenses while you recover from a temporary disability, such as a broken bone, a surgery, or a pregnancy. STD typically pays you 60% to 70% of your pre-disability income.

Long term disability insurance (LTD) covers you for a longer period of time, usually until you reach retirement age or recover from your disability, whichever comes first. It kicks in after a waiting period of several months, usually after your STD benefits run out. LTD is designed to help you maintain your standard of living while you cope with a permanent or chronic disability, such as cancer, stroke, or multiple sclerosis. LTD typically pays you 50% to 60% of your pre-disability income.

As you can see, short term and long-term disability insurance have different purposes and benefits. That’s why it’s recommended to have both types of coverage if you can afford it. Having both STD and LTD can ensure that you have a steady source of income no matter how long your disability lasts. You can buy disability insurance through your employer or on your own. The cost of disability insurance depends on several factors, such as your age, health, occupation, income, and the amount and duration of coverage you choose.

Car Insurance

Car insurance is a legal requirement in just about every state.  For example, you will be fined a minimum of $450 if you don’t have current auto insurance in Washington State.  It also provides financial protection and peace of mind in case of an accident or theft. Here are some of the primary considerations when purchasing car insurance:

– Coverage: The type and amount of coverage you need depends on your personal situation and preferences. Some common types of coverage are liability, collision, comprehensive, personal injury protection, uninsured/underinsured motorist, and roadside assistance. Each one covers a different aspect of potential risk and has a different cost. You should compare the benefits and limitations of each type of coverage and decide what suits your budget and needs.

– Discounts: Many insurance companies offer discounts for various reasons, such as having a good driving record, being a loyal customer, having multiple policies with the same company, having safety features on your car, taking a defensive driving course, or being a student or a senior. You should ask your insurance agent or broker about the discounts you may qualify for and how much they can save you.

– Reputation: The reputation of the insurance company is also important when purchasing car insurance. You want to choose a company that has a good track record of handling claims fairly and efficiently, providing good customer service, and offering competitive rates. 

Regardless of whether you go direct to an insurance company or access insurance products through an agent, it is a good idea to do a background check.  Insurance is regulated and you can check out an insurer’s national complaint statistics by accessing the National Association of Insurance Commissioners’ Consumer Information Source.  You type in the name of the Insurance Company, the State where you live and the type of insurance.

It’s a good idea to check out the complaint ratio which shows the ratio of the company’s US market share of complaints as compared to the US market share of premiums.  If the complaint ratio is higher than the national median this could be a reason to look at an alternative provider.  It’s also good to review the trend of this ratio…are they getting better (decreasing) or worse (increasing).

Be Mindful of Conflicts of Interest

Be mindful of conflicts of interest.  There are many honest folks that sell products when they are paid on a commission but there needs to be transparency on all conflicts.  Insurance products, which are complex, are often sold through agents who are paid a commission. Complexity and commission-based compensation can create conflict of interests when it is very difficult to compare one policy vs. another.  In a recent blog post, Integrity, Trustworthiness and your Best Interest Matters when considering a Financial Advisor, I discuss conflicts of interest.

An agent that sells a life insurance policy may receive 50-60% of the first years’ premiums and then 5-10% for annual renewals.  Some agents only sell products from one insurance company referred to as “captive” which reduces your options.  When buying insurance offered through your employer, the employer, will interface with the insurance provider, not you.

Buying insurance directly from the insurance company means that you can shop around and compare prices and features online. You may be able to find lower rates or more options than through an agent. You may also enjoy more convenience and flexibility, as you can buy or change your policy anytime and anywhere. However, buying insurance directly from the company also has some challenges. You may not get personalized advice or guidance from a professional, which can make it harder to choose the right coverage for your needs. You may also have to deal with customer service or claims issues on your own, without an agent’s support.