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Insurance is probably the most expensive product sold that is the least understood. Nearly 1 in every 12 dollars spent in our economy goes to pay for some type of insurance (6.8% of all household spending in 1993). Studies by the nonprofit National Insurance Consumer Organization show that more than nine in ten Americans purchase and carry the wrong types and amounts of insurance coverage. By contacting your state's Department of Insurance you might be able to compare rates for your area for different insurance products. Life is filled with uncertainties (accidents, illness, disability, death, fires, floods, earthquakes, etc.) which require us all to take risk daily. The purpose of insurance is to allow us to transfer the unacceptable risk of loss to someone else. Understanding risk management is the first step in planning for insurance needs. Making wise decisions when purchasing insurance requires that you have an understanding of the basics.
Simply put, there are two categories of insurance:
and
Could it happen to YOU? Are you prepared?
The unknown
CAN happen. Catastrophic losses DO occur. Even the best financial plan can
fail if it doesn't consider risks such as death, disability, personal
liability and loss or damage to substantial assets.
Making informed decisions about insurance means becoming better acquainted with the risks that you and your family face. You need to decide whether to work toward avoiding certain risks altogether, to insure some risk or to simply accept that you will be exposed to some risks and will count on your own resources to cover those risks.
One or more of these approaches can be appropriate for a given risk. It is difficult and complicated -- but very important -- to decide when to and when not to insure. The Risk Management Process described below can help you make those decisions.
Five Key Steps
- Define Potential Risks and Financial Consequences
- Determine the Length of the Exposure
- Develop a Strategy for Each Risk
- Set Priorities for Coverage
- Monitor Risks and Coverage
Each step is described below.
Define Potential Risks and Financial Consequences
The first step is to define the risks that you and your family face. Obvious everyday examples are the risk of loss of your home to fire or the risk of damage to your automobile in an accident. Personal risks include poor health, disability or unexpected death. Other risks may be less obvious. Are there special liability risks associated with your work or with participation in community activities? Are you indirectly responsible for the long-term care of your parents or adult children who need financial help?
You must examine your situation carefully to make sure that you have identified and defined the scope of all significant risks.
After you identify the risks, it is important that you then measure the financial consequences. What are the dollar amounts at stake?
For example, if you or your spouse dies prematurely, the long-term financial security of your family may be at risk. A measure of the risk is the amount of money needed to replace your family's current income (let's assume $50,000 per year).
Determine the Length of the Exposure
How long will a particular risk continue? How will it change over time?
The risks to which you and your family are exposed will vary over your lifetimes. Once you've estimated the initial financial consequences of a risk, then you need to estimate how long the risk may continue and how the financial consequences may change with time.
For a family spending $50,000 per year now, what are the financial consequences of the premature death of the family's primary income earner? There are several things to consider.
Suppose that the children in the home will be in school for ten more years, including four years of college. After all the children are finished with college, the surviving spouse intends to return to work and generally be self-sufficient within three years from a financial perspective.
The facts so far suggest a time frame over which the risk exposure will last and show how the amount of the risk can change over time in reasonably predictable ways.
With these facts, knowledge of the specific circumstances and goals of the family and a calculator, the family can begin to estimate the total exposure over time and, with the help of an advisor, determine an amount of life insurance coverage that makes sense.
A final point: some risks cover extended periods of time. In those cases, it's important to assess the impact of inflation when estimating the risk exposure. Thus, the family in our example may want to build in an assumption of inflation in defining its life insurance needs.
The important point is that you begin to think about each risk that you and your family face in specific financial and time-oriented terms.
Develop a Strategy for Each Risk
Managing risk does not only involve buying insurance. Other strategies may be more appropriate, the costs associated with a risk are so great that the best plan is to avoid the risk altogether. An example is not building a house in an area that is frequently flooded.
In other situations, the cost or probability of the risk may be relatively small, so the best approach may be to simply cover the risk yourself.
For example, you do not have to plan extensively for a $25 kitchen appliance because cost of a total loss is insignificant. Similarly, managing the risk of being struck by a meteor is not justified because the chances are so remote. These extreme cases are easy.
In contrast, many risks that are sufficiently likely to occur or would be so costly if they do occur simply cannot be ignored. In these situations, insurance can make the economic consequences of the risk more manageable by shifting some or all of the exposure to an insurer.
Earlier, we reviewed the situation of a family estimating the financial consequences of the premature death of the primary income earner. The family's strategy for managing this risk might include:
- Consulting with an insurance advisor.
- Deciding to assume part of the risk with personal savings and investments.
- Purchasing a term insurance policy in an amount to cover the years when the risk is greatest.
- Planning to decrease the amount of term insurance for the later years when the exposure is reduced.
Your next step is to prioritize the risks based upon which are most important to you and the seriousness of the financial consequences. If your resources are limited, setting priorities will help you decide which risks to deal with first (see BUDGET). At a minimum, develop a plan that addresses the risks that are sufficiently likely to occur and that would have the most immediate financial consequences. For example, you may decide to have homeowners' insurance because the risk of theft or damage is sufficiently likely to occur and the consequences could be expensive.
Also consider whether you can devote some portion of your insurance budget to covering risks that may be remote but that could have consequences. Acquiring an "umbrella" or excess liability policy to protect against personal injury claims might be one example.
Over time, as additional resources become available, you can address additional risks that may have greater long-term consequences.
Over time, the risks you face will change. At least once a year, you should set aside time to review the effectiveness of your risk management game plan. You may need to address new risks or reassess how you are addressing previously identified ones. For example, if your health has deteriorated since you last considered your life insurance, you may find acquiring any new coverage difficult or costly.
Your yearly review is also a good time to review the cost effectiveness of your insurance coverage. Insurance market conditions change in response to the economy and many other uncontrollable external influences. As market conditions change, often so do premium costs. You may find out about lower cost alternatives during your review.
Schedule time now for your own risk management and insurance checkup!
(click here for printable version of the insurance overview above)
