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Lesson 4a: Planning & Insurance Basics

Objective: Understand how to manage financial risk.

Now that you know where you stand with your budget and net worth, the next step is to protect your financial future.  This planning section is about managing your financial risks and understanding your future needs including retirement and children's education.  Planning will help you by identifying risks such as:

  • Having enough money for a long retirement
  • Needing medical treatment and knowing if your insurance covers it
  • Becoming disabled and having insurance or assets to cover you past 90+ days of short-term disability coverage that you may or may not have
  • Having a change in the family situation (new child) that comes with additional expenses and possibly loss of income

Before we discuss planning more, it is important to understand the term "financial risk" and how to manage it.  Financial risk measures the possibility of a loss and the variability of the potential loss.  For example, if we say there is a 10% chance of having an automobile accident in any given year, and the loss of the accident is $5,000 in 50% of cases and $100,000 in the other 50%, there are two different risks to consider.  First, there is a 10% chance of having an accident, and second, there is variability in the potential loss from an accident ($5,000 vs. $100,000).  As another example, consider visits to the dentist twice a year for routine cleaning with a fixed $75 fee for each visit.  There is very little risk in this situation because the outcome is predictable and fixed.  Thus, if there is no variability in the number of visits or the cost of each visit, there is no risk.  The greater the variability in the number of occurrences and/or the cost of an occurrence, the greater the risk. 

Risk is present in every aspect of life, from losing money on investments to getting into a car accident.  To save money, there are some situations where you may want to assume risk (e.g., investment gains and losses) in order to increase your wealth, while in other situations you will want to reduce your risk of financial loss (e.g., a car accident).  When you want to reduce your risk of financial loss, there are several ways to reduce your risk, including:

  • Avoidance - You can reduce your risk of death by avoiding risky activities like sky diving.  You can reduce your risk of a car accident by driving less and taking public transportation.
  • Proactively manage the situation - You can reduce your risk of death by improving your diet and exercising.  You can reduce your risk of car accident by taking a defensive driving course.
  • Diversify risk - You can have different types of investments (e.g., stock, bonds, real estate) which will reduce your overall financial risk compared to having all your money in one type of investment.
  • Transfer risk - Even though you can not transfer your risk of death or having an automotive accident, you can transfer the financial risks associated by these events by buying insurance.

Perhaps the most well known way to reduce risk is to buy insurance.  There is insurance for almost all financial risk from automobile insurance to insurance for identity theft.  Yet, insurance can be a costly proposition, and it may not feasible to transfer all of your financial risks.  Insurance is good in that it can help you avoid total financial ruin by having large insurance companies pooling the risk of needing costly medical treatment, for example.  Yet, to take on the risks, insurance companies need to add on additional costs to cover their operating costs.  The premium charged for insurance is made up of four parts:

  • Cost of risk - This is the financial payout that an insurance company makes to cover the policy holder's losses.
  • Business cost - This is the cost of hiring claim agents, lawyers, and actuaries to write and administer the policies.
  • Profit - A business needs to make a profit for its investors.
  • Agent/broker commission - Your friendly neighborhood agent gets a fee for selling you the policies.

So it would not be uncommon for an insurance company to add on 20% or more to the amount needed to pay out losses in order to cover the other costs (salaries, commissions, profit).  Thus, when you buy insurance, you may want to focus on items that have a large risk (a large amount of uncertainty) and not those with smaller risks that you can manage yourself with proper planning.  For example, keeping some financial risks like deductibles on insurance can lower your overall costs.  It is normally cheaper to self insure the cost of a $400 fender bender by having a $500 deductible rather than having a lower $250 deductible.  This is because the $400 fender bender would cost the insurance company well over $500 once you factor in the other costs, and they would pass this cost on to you.  On the other hand you would not want to assume all the risk of driving because a serious automobile accident could be very costly.  Thus, self-insuring smaller risks can save you money, however, self-insuring large risks can be disastrous.  For example, medical costs can quickly grow out of control and thus are a leading cause of personal bankruptcy.  So, if you are considering not buying health insurance due to the cost, at least consider buying catastrophic health insurance that will cover your health costs above a certain amount in case you get seriously ill or injured while saving some cost by self-insuring minor medical claims.    

Financial Topic : Planning Insurance
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