We like to feel like insurance can protect us from anything. When we get hurt, our health insurance picks up the tab. Car accident? Car insurance will pay for most of it. Death? There's life insurance to take care of that (wait a minute...).
The point is that we so often buy insurance because we're afraid of what could happen to us. That is, our decision to insure tends to be reactive rather than based on real reflection about what the specific coverage will cost and what it will actually do for us if our worst fears are realized.
And because there's insurance for just about everything you can possibly imagine, it can be hard to know when to say no. The good news is that there's one very practical rule that applies to buying insurance (along with a whole lot of other things in life). Ready for it?
And just like you might apply moderation to how much you eat or how much time you spend playing Angry Birds on your smartphone, making decisions about insurance coverage involves using your common sense. Here's how...
The big gamble
The problem with insurance is that it essentially involves making a bet that something bad will happen to us. In terms of thinking rationally, this puts many people in a tailspin. After all, if something can be insured, it seems real, tangible, possible. And it is. But just about everything and anything is possible, now isn't it?
The reality is that the insurance industry wouldn't be profitable — or even solvent — if all these insurable events actually happened to everyone. More often than not, we don't crash our cars, our homes don't burn down and we avoid most major accidents. But the question still remains: what if it did happen to me?
You see, the hardest part of deciding what insurance coverage you actually need is examining your fear of what could happen. No one likes to think about a worst-case scenario, but buying insurance shouldn't be like bringing an umbrella to a picnic. In most cases, it's too costly for "just in case."
What you really need to do is consider how likely an insurable event is, and then compare what it would cost you to pay for that event, compared to what you have to pay in insurance premiums. This means making the same sort of bet on yourself that insurance companies make when they insure you. The key is to ensure that you're making a bet you can afford.
You win some, you lose some
Car collision insurance provides a perspective on this equation. We all cringe at the notion of running into another vehicle. As such, we often accept collision coverage without even thinking about the alternative. In this way, if we do make the wrong decision and wind up with a dent in the bumper, we can make it go away with as little pain as possible.
However, while paying for this type of insurance may reduce the psychological pain of a car crash, it may not do much for the damage to your pocketbook. Suppose, for example, that you're insuring a young driver with a cheap first car. In this case, collision insurance can cost as much as an additional $100 per month. If that driver is motoring around in an old beater that's worth $6,000, it could be totaled and replaced every five years for the same price as the insurance - in which case it may make more sense to start a savings account for possible damages instead.
Now, if collision insurance might not be in your best interest, just imagine how unlikely you are to benefit by insuring your pets, your modest credit card balance or your new big screen TV.
This isn't to say you should ditch insurance altogether. In fact, there are some things that are just too big to gamble with, like your home, your livelihood and your family's well-being. Why are these things worth insuring when so many other things aren't? Because they aren't things you can generally cover out of pocket, and the consequences for you if they do happen are just too big.
Know when to walk away
If there's one thing to understand about insurance, it's that the odds of a payout generally aren't in your favour (thank goodness for that), especially when the premiums are affordable. After all, if everyone who was insured collected money, the system would collapse in a matter of days. This is what allows your insurance company to make a big payout when things really do go wrong.
Now apply this principle to your own situation: if the insurance company thinks the odds are in its favour, why would you bet against yourself? The answer is you wouldn't, at least not when the stakes are low enough. Exactly where that tipping point lies depends on your personal financial situation, so it's up to you to do the math.
Insure and save
When it comes to insurance, speak to your advisor or insurance professional about conducting a needs analysis in order to determine the right mix and type of coverage for you. Ultimately, it makes sense to insure what's most important and set up a savings account to take care of the rest. And remember that the best that insurance can do is provide financial compensation for accidents, injuries and other disasters — it can't undo them. If buying it doesn't stack up financially, it doesn't stack up at all.
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Nothing contained herein is intended to provide personalized financial, legal or tax advice. Before implementing any financial or legal strategy, you should obtain information and advice from your financial, legal and/or tax advisers who are fully aware of your individual circumstances, as well as fully aware of current laws and regulations.