CHAPTER 5
The Gift of Discernment
RISK MANAGEMENT DECISIONS
If you purchased insurance for everything for which it was created, you wouldn’t have any money left. You manage risk, however, every day whether you know it or not. Do you wear a seat belt? You’re managing risk. Are you a boater? You’ve made a risk management decision. Do you look at the number of calories or grams of fat before you eat something? You’re a risk manager. A greater understanding of risk management techniques will help you make better insurance decisions. You’ll know when you need insurance or need better insurance, and you’ll also know when you need less or no insurance at all. Proper risk management results in less stress—because you’re not wondering about issues you haven’t addressed—and a healthier personal bottom line.
There are two broad risk categories on which we will focus: personal risk and financial risk. Many single risk management decisions have both personal and financial risk components. For example, the invigorating pursuit of mountain climbing has the personal risk of injury, even fatality, and the financial risk of the cost of medical bills. Regardless of your action or inaction, you have made a risk management decision.
Timeless Truth
To paraphrase the Surgeon General of the United States, life may be hazardous to your health. All of us know that bad things happen to good people, and none of us are destined to get out of this life alive. There are few things less sexy, attractive, or appealing than thinking about insurance. When most of us think about insurance, we have visions of dealing with people we don’t enjoy, while discussing things we don’t understand, and considering possibilities we don’t want to think about.
When we buy a new car, new clothes, or a new house, we feel energized and want to share our new purchase with friends and family members. When we buy insurance, we get an envelope full of legalese and an endless string of bills, neither of which are anything we want to share with those we care about. Unfortunately, for most people, insurance is a reality of life, at least during certain times in the growth and development of your family.
There are few things less important in our minds than insurance when we don’t need it and almost nothing more important than insurance when we do need it. Insurance is like an umbrella that simply gets in the way until you find yourself dressed for an evening out while getting out of the car in a driving rain. That which was useless suddenly becomes imperative.
For anything as confusing as insurance, you and I need a guide or an advisor to lead us through the process. Unfortunately, the vast majority of insurance policies were sold to consumers by commissioned salesmen instead of being bought by informed consumers. When it comes to insurance, what you don’t know can definitely hurt you.
While you are building the life of your dreams with those that you care about, be sure to create a layer of protection between your future and a world full of opportunities—but also disasters—waiting to happen.
Jim Stovall
There are four primary risk management techniques: risk avoidance, risk reduction, risk assumption (or self-insurance), and risk transfer (or insurance). Let’s analyze a real-life example to illustrate the various techniques.
The summer I was 18 years old, I was a punk. You know, a cocky know-it-all who would rather stick a hot poker in his eye than respond positively to any authority figure. I was invincible and omniscient. That’s why I knew that even though police officers had given me three separate violations for driving without a seat belt, I had nothing to fear driving around without shoes or a seat belt. To say I learned several lessons the hard way that summer is an understatement.
I spent the summer after my freshman year of college working, if you can call kicking back on a platform soaking in the sun while twirling a whistle around your finger and occasionally calling out “Adult swim!” work. After I clocked out on one particular Tuesday in June, I did what I did every summer Tuesday (and Wednesday, and Thursday . . .)—find the party. I partied until a friend drove me back to her house where I slept off the day’s activities.
Feeling sufficiently rested at 2:00 a.m., I got in my car to drive home. Ten or so minutes later, I was awakened to the sound of my tires hitting rumble strips, and before I could respond, the car descended over an embankment.
Because I wasn’t wearing a seat belt, I bounced all around the vehicle as it rolled down the embankment, finally resting on its wheels. My right femur (the longest bone in your body) was visibly broken. I had also suffered a broken pelvis and several internal injuries as I’d later learn. Possibly because I had watched too many action movies, I had an irrational fear that the car would explode, so I tried to open the driver door and then the passenger door to escape before the impending explosion. When they wouldn’t open, I painfully crawled into the back seat. Neither of those doors would open either. I didn’t know that the car metal had rolled down over the doors.
Lying there in the back seat, I moved in and out of consciousness for hours. It wasn’t until 6:00 a.m. that a truck driver finally spotted my car from above and notified emergency responders. I can’t report that I was brave and unflinching, that I fought for every breath to cling to life. I actually gave up. The last thing I remember hearing was the sound of a helicopter and a voice saying, “This doesn’t look good. I don’t think this kid is going to make it.”
Over the next two weeks, the doctors and nurses in Baltimore’s legendary University of Maryland Shock Trauma Center, buoyed by the prayers of family and friends, saved my life. They said I was only minutes from bleeding to death in the car. Shortly after I arrived at the hospital, my left lung collapsed and plastic tubes were inserted to help me breathe. After fighting the machines that were providing my oxygen, they induced a coma, in which I remained for five days. I learned later that my chances of living fell below 10 percent. Because this is a financial book, I should point out that those are not favorable odds.
Ultimate Advice
I may not have had the money Jason Stevens had in The Ultimate Gift, but I certainly possessed his pre-Gift attitude. My selfishness, sense of entitlement, penchant for rule-breaking, and lack of regard for authority were unable to lead to too many financial problems only because the accident nearly took my life first. I’d love to tell you that once my critical condition was stabilized I changed dramatically for the better, but I didn’t. In contrast, my heart became even harder and my behavior more dangerous prior to a series of revelations that continue to change me to this day from the inside out. Most of our problems—in money and life—are rooted in some form of self-deception helping us cling to our personal worldview that we are at the universe’s center. The first step, therefore, in every financial or life plan is simply to be honest with ourselves!
Tim Maurer
Why do I tell you this story? Because I think it will help you remember the concept of risk management. Let’s examine the personal and financial risks that I faced and the various risk management methods in the example of an automobile accident:
- Risk avoidance: There is only one way to completely avoid the personal and financial risk of an automobile accident. Don’t drive. Every time we get in an automobile, we give up the ability to avoid the inherent risks associated with that activity.
- Risk reduction: This was my biggest area of weakness on the risk management front. In the personal injury category, even if I had insisted on doing everything else wrong, I could have worn a seat belt. This still may have been a serious accident, but it would not have been a life-threatening one. Certainly, driving at 2:00 a.m. after a day full of working and partying in the sun is a risk that could have been easily mitigated. On the financial front, all of the above foolishness applies, because when irresponsible behavior leads to a life-threatening accident, it takes a lot of money to put you back together. But, on a more generic front, a financial risk management method regarding auto usage is drive cautiously. If you drive cautiously, you’ll have fewer accidents costing you less money, and you’ll also decrease your insurance costs significantly for having a driving record free of accidents and tickets.
- Risk assumption: Do you remember when I mentioned that doing nothing is still a choice? This was the personal risk management method I chose. Despite the seemingly blatant logical flaws, 18-year-old men seem to truly believe they are invincible. For this reason, I chose to go without a seat belt even after repeated violations and fines for not doing so. I self-insured my personal injury. I didn’t need anyone’s help to protect me. I was a competent driver and had conquered far worse than a 20-minute drive home at 2:00 a.m. I laughed off the personal risk and assumed it myself. Financial risk assumption in the case of a car accident is going without insurance.
Fortunately, I did have both auto and health insurance, but not of my own choosing. Were it not for the legal mandate to own car insurance, I wouldn’t have had any. And who needs doctors or health insurance when you’re 18 and invincible? I was fortunate enough to still be on my parent’s health insurance plan because I was enrolled in college.
- Risk transfer: Insurance is the transfer of risk from one party to another. Much of the risk in life can be avoided, reduced, or assumed, but many of life’s catastrophic risks require deeper pockets. That is where insurance is very helpful. I can assume the risk of my auto insurance deductible. I can’t assume the liability risk of someone suing me for $1 million if I have a car accident, so I transfer that risk with auto and umbrella insurance. I can assume the risk of replacing the hot water heater in my house. I can’t assume the risk of rebuilding my house and replacing its contents if they burn to the ground, so I transfer that risk with homeowner’s insurance. I can assume the risk of what it would cost to bury me if I die prematurely. I can’t yet assume the risk of replacing my future income for my wife and children, so I transfer that risk with life insurance.
How does insurance work? You need to understand one word to understand insurance—pool. This is not a hole with water in it, but a risk pool. You are not the only one with risks you cannot avoid, reduce, or assume. An insurance company takes you and a huge number of others like you and throws you into a common risk pool. Brilliant numerical wizards called actuaries make determinations of the probability of certain risks occurring over various periods of time. After having done so, they can derive the estimated cost of claims in a set period of time. That cost, when broken down across each of the individuals in the risk pool, along with a built-in profit for the insurance company, becomes your premium. Added to that number is an additional premium if your past behavior or circumstances make you a higher risk than the average in the pool. Subtracted from that number is a discount if your past behavior and circumstances make you a lesser risk.
You say it sounds like gambling. It is, but with people much smarter than your poker buddies. And as it applies in Atlantic City and Las Vegas, yes, the house always wins. Insurance is not an investment. Those who claim it is are lying and may be breaking the law (the laws are different in each state). Some insurance products have internal components accruing cash that in some cases is invested in mutual fund–like vehicles, but you must never forget that there is always a cost to the insurance and that is the primary purpose of the product. We’ll get into greater detail on this in the life insurance chapters.
You say it sounds like discrimination. It is. It’s legal (and arguably appropriate) discrimination, and with the exception of your race or creed, just about everything else is up for grabs. For reasons that should now be entirely apparent, 18-year-old men pay significantly more for auto insurance than 18-year-old women or even 25-year-old men. It is both sex discrimination and age discrimination. Men pay more for life insurance than women because, statistically, they have a higher chance of dying earlier (plus they drink more beer and eat more junk food). Again, sex discrimination. Women pay more for health and disability income insurance because they have the ability to become pregnant. You get the idea.
If you are the healthiest person on earth but your mom or dad died of a heart attack in their 50s or younger, you will pay more for health insurance. If you take any kind of antidepressant, you may be denied long-term disability income insurance altogether. The older you get, the more you will pay for life, disability, long-term care, and health insurance. On its face, insurance is the business of discrimination, but if they didn’t discriminate, insurance wouldn’t exist.
Economic Bias Alert!
There are few transactions in which economic bias is any more present than with insurance products. Most of the people who are in the business of helping people make insurance decisions are people who benefit economically from the consumer’s decision to purchase said insurance (I know that’s a shocker!). So inevitably, most insurance agents have an innate tendency to prefer that the consumer buys the product or products that he or she sells or represents.
Despite the caricatures, most insurance salespeople are not bad people. They are simply salespeople. Their training is often heavy on sales and light on advice. Most of them know their stuff and many even carry legitimate credentials (like the Certified Financial Planner™—CFP®—credential), but if they profit when you buy and they don’t when you don’t; you need to know that. Understanding this bias will help you make a more informed decision.
If you want advice with less conflict of interest, pay a fee-only CFP® practitioner to review your various insurance coverages and make recommendations. And don’t hesitate to ask the question of the salesperson that is bound to ruffle feathers, “How much will you make off of the sale of this product?” The answer is absolutely material. The higher the commission, the more context you have to make your decision.
Many bemoan the cost of insurance and say, “See, I paid thousands of dollars into this policy that could’ve been growing in my investments. What a waste!” It is my fervent hope that all of your insurance premiums end up being a waste of money. You don’t buy insurance for the service that is required at an auto body shop, at a hospital, or from a home builder. You buy insurance on an annual basis to transfer the risk of needing to utilize those services unexpectedly. Would you feel better if you had the car accident, became disabled, or died, but got some insurance money out of it?
Ultimate Advice
Never ask a barber if you need a haircut.
Warren Buffett
Even as an 18-year-old punk kid, I could have completely avoided my accident using only one technique, risk avoidance, by not driving at all that night. However, let me be clear; it is not my intent to suggest that your life should be one big exercise in risk avoidance. Many of the things that give us the greatest enjoyment in life carry with them inherent risks. And despite my nightmarish story, I actually still have a natural attraction to that which is personally risky. I love rock climbing, cycling, white water rafting, and riding motorcycles; but I climb with ropes, bike with a helmet, raft with a guide, and have agreed with my wife that I’ll not own another motorcycle until my boys are adults and college is paid for. Risks are best managed when all of the techniques are used together.
Timely Application
Risk Management Matrix
The way to see activities through a risk management lens is to go through some ideas of your own, like my example of the car accident, and discuss or jot down the ways in which that risk could have been managed with each of the four methods. It doesn’t have to be something as dramatic or painful. It could easily be a risk management success story that you can now better understand.
Examine both the personal and the financial risk using all four of the risk management techniques. After doing that exercise, discipline yourself to analyze a few other examples throughout the course of your days. If you’re bold enough, teach the technique to a friend or family member (there’s no better way to learn something than to teach it). Eventually, it won’t be work, and you’ll see your options more clearly. Then, when you examine your existing insurance products or new offerings, look for ways you can reasonably avoid, reduce, or assume the risk before paying someone else to do it for you.
Visit www.ultimatefinancialplan.com to find a template to use in creating your own Risk Management Matrix.
Tim Maurer
Through the first five chapters, we’ve provided a strong foundation for managing your personal finances. Next, we’ll discuss how to protect that foundation and your future plans. In the next three chapters, we’ll specifically address the primary areas of risk most often associated with the purchase of insurance: life insurance, home and auto insurance, health insurance, long-term care insurance, and disability income insurance. We’ll make recommendations for insurance’s best uses and point out its misuses and abuses.