CHAPTER 26

Intro to Insurance: Countering Risky Business

We’ve introduced the role that risk plays in your investments and how your level of risk tolerance will affect decisions regarding what you choose to add to your financial portfolio. Another element of your overall financial strategy—and one that directly addresses elements of risk—is insurance. There are many types of insurance products available and each of them addresses elements of risk in its own way.

When considering risk for insurance purposes, we need to define it within that context. Risk, as viewed by insurers, represents the chance of some type of loss or the possibility of a loss. It also represents uncertainty regarding what the future may bring. Risk, in the context of the insurance arena, can also encompass the possibility of a variation from the actual expected result of something. Essentially, we are looking at any potential future event whose outcome could harm us that we wish to protect ourselves from—to the fullest extent possible.

The function of insurance is to transfer risk. When you purchase an insurance product, you are transferring risk from yourself to the insurance company. Are the insurance companies doing this because they feel sorry for you and have an altruistic desire to help you out? No chance. They are doing it to earn a profit. How does the insurance company accept this risk from you and make a profit? The goal of the insurance company is to pool together a large group of insured people, which they refer to as “exposures,” to help mitigate the risk that they are assuming. It works for them in exactly the same way as having a well-diversified portfolio of investments helps you mitigate the risk of loss inherent in your investments. By putting together a large group of exposures, they understand that a certain number of them will never have an event that will cause the insurance company to pay on their policy, while a certain number of them will. The insurance companies employ vast teams of people, known as actuaries, to calculate these probabilities of events happening and the number of people expected to be affected by these events. They use this data to determine the price they need to charge for the insurance policy. This helps to ensure that the insurance company will make a profit on the insurance product, despite the fact that they will incur the cost of paying out money for some of the claims. Another important concept of insurance to understand is indemnity. Indemnity means that the insured person is only entitled to compensation from the insurance to the extent of their loss. In other words, you, the insured, cannot make a profit from the insurance. One final basic term to be familiar with is warranty, which represents any promises that you are required to make to the insurer in order for the policy to be in effect. For example, a health insurance policy may include a warranty that you do not smoke.

Common Types of Insurance Related to Personal Finances

We have already discussed one type of insurance provided by the federal government for cash deposits that you hold with banks or credit unions. It is supplied by the FDIC for bank accounts and the NCUA for credit union accounts. You are automatically covered by this insurance for those cash funds at banks and credit unions up to the maximum insurable amount. There are some other common types of insurance that pertain to your personal finances that may be good to consider for your overall financial strategy, which you would need to purchase on your own. Of course, there are also types of insurance that could pertain to your art—such as film production insurance. For our purposes here, however, we will be only looking at some insurance products that could relate to your personal finances.

Health Insurance

Health insurance is something that young, freelance people often go without in order to save money. I will confess that early in my career, I was one of those people. I figured that I was young and healthy and would rather take my chances than spend the money on a premium. At that time it was also more difficult—and much more expensive—to find a health insurance plan if you were self-employed. Fortunately for me, I never had any major illnesses and the most serious dance injury I sustained—a torn calf muscle—occurred while I was in rehearsal. This meant that my treatments and therapy were covered by the dance company’s insurance and worker’s compensation. Since the passage and implementation of the Affordable Care Act (signed into law in 2010), it is now much easier to find a health care plan that will suit your needs and fit within your budget. You would certainly not want the costs of an unforeseen illness or injury to wipe out the investments that you have been so diligently building. The purpose of health insurance is to mitigate health risk—the risk that you would require some form of medical treatment resulting in expenses that would overwhelm you financially.

Home Insurance

A form of home insurance can be purchased both by people who own their homes and by renters. These policies typically cover the contents of your home or apartment. This would allow items to be replaced if they are damaged or destroyed due to events such as a fire or flood. Homeowner’s insurance can also be designed to cover unexpected structural repairs, such as to your roof—something with which those of us living in apartments typically don’t have to be concerned. It also usually covers the costs of temporary housing if you would be unable to stay in your home or apartment for a period of time due to the damage. My friend Noreen was forced to stay in a hotel for several weeks due to a fire in her building. The fire was not in her apartment but rather in another tenant’s. There was extensive smoke damage to her belongings and her apartment needed to be professionally cleaned. Repairs also needed to be made to the building. This meant that she was unable to stay there for an extended period of time. Fortunately for her, she had a renter’s insurance policy that covered all of the necessary cleaning as well as her hotel stay while repairs were being made. Without it, her expenses could have added up quite quickly and quite extensively.

Another common element of a homeowner’s or renter’s insurance policy is liability coverage, in case someone is injured while at your home or apartment. Typically, this would cover the cost of treatment for a person’s injuries as well as any liability for which they may try to hold you accountable. The annual cost of homeowner’s or renter’s insurance is typically quite low. This makes it well worth considering for the potential housing-related risk that it mitigates.

Annuities

Annuities are products sold by insurance companies that resemble financial products. They are an insurance contract that is designed to provide payments to the holder at specified intervals, usually for a fixed period, during the holder’s life. They often also include a guaranteed minimum rate of return on funds that are invested in the annuity but may incur a penalty if you need to withdraw any of the principal amount prior to a set deadline. Annuities are often incorporated into retirement planning due to this arrangement of regular payments and/or guarantee of a specified rate of return. An immediate annuity would start paying you immediately after the first specified interval, while a deferred annuity would start paying at some specified point in the future. Insurance companies are frequently creating new types of annuities to sell. Following is a description of two of the most common types.

Fixed annuities are contracts where the insurer agrees to pay a specified interest rate on the funds within the annuity contract. Essentially, you give the insurance company a sum of money and they agree to pay a guaranteed return on it. This type of annuity provides more security for the principal amount in the contract, but has only limited potential to take advantage of significant upturns in the market. In other words, if other types of investments begin making returns that are much greater than the fixed rate on your annuity, you may not be able to experience that benefit. However, your initial investment will also not be subject to the same risk as those other investments that are subject to market fluctuation. Also, your fixed rate would be beneficial in the event that returns on other investments began to drop, as you will continue to get the agreed-upon fixed rate.

Variable annuities allow the funds within the contract to be invested and allocated among sub accounts. These sub accounts could then be invested in stock, bonds, or both and are professionally managed. This type of annuity carries more risk regarding preservation of the principal amount—due to market fluctuation—but increases the potential for better gains.