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Insurance Is a Financial Planning Tool

The path to financial independence requires diligence and hard work. It would be a tragedy if all that effort is undone with one uncontrollable incident. While predicting what specific event may occur is virtually impossible, we can prepare for the fact that “something” may happen. Insurance is a financial tool that transfers the catastrophic risk of events we cannot predict into smaller monthly expenses we can plan for in the form of insurance premiums.

In addition to the “peace of mind” it provides, insurance is a financial tool critical to helping manage the things in life outside of our direct control. Simply put, the purpose of insurance is to control risk. We cannot stop floods, fires, hurricanes, or tornados from destroying our home. As careful as we might be behind the wheel, accidents will happen, sometimes resulting in loss of life or tremendous liability costs. And nothing may be more unpredictable than our health.
  • How Insurance Works
  • What Insurance Do You Need?
  • Controlling Insurance Costs
  • Homeowners Insurance
  • Auto Insurance
  • Health Insurance
  • Other Insurance Policies to Consider
  • The Bottom Line

How Insurance Works

There are different types of insurance, but the policies worth considering are homeowners/renters, auto, health, disability, long-term care, life, and umbrella insurance. You select the type of insurance and the amount of coverage you need and purchase a policy. The premium is charged upfront, in an annual lump sum, or via multiple payments, such as biannual or monthly payments. Depending on the terms of the policy, there may be a deductible amount to consider. A deductible is the amount of damage the insured person pays before the insurance policy coverage pays. In general, the higher the deductible, the lower the premium payments. And the opposite is also usually true, the lower the deductible, the higher the premium payments. The customer is faced with the decision to accept more risk with a higher deductible or lock-in higher sunk costs with more costly premiums. When the unexpected happens to the insured person or property, the insurance company pays for the damages according to the terms of the policy, minus the previously agreed upon deductible. Insurance is the one item in life that we pay for and hope to never need to use. But don’t think of it as a waste of hard-earned dollars. Insurance is a financial tool and a critical part of the roadmap to building wealth and protecting our loved ones. Listen: Insurance: A Framework

Insurance Terms to Understand

You can’t make informed decisions without first understanding some terminology insurance policies use to describe what your potential costs might be. Let’s review each of them.
  • Premium–The amount the policyholder pays each month for the selected coverage
  • Deductible–The amount of money the policyholder is responsible for before the policy covers any costs losses. For health care plans, deductibles may be per individual or family.
  • Copay–The fixed amount that the policyholder pays with each medical service or fee AFTER the deductible is met.
  • Out-of-Pocket Maximum–The maximum amount of money the policyholder will have to pay for covered services in a year.
One item you never want to try to lower is a health  insurance company’s maximum payout. This is the total amount the insurance company will pay for your care. Instead, you want the highest limit possible.

What Insurance Do You Need?

You can purchase insurance for just about anything. In the 1970s, Gene Simmons from the rock band, KISS, had a $1 million policy insuring his famous tongue. Another fun fact is that Lloyd’s of London has written over 20,000 policies covering people in the unlikely event aliens abduct them. Just because you can insure something or someone, it doesn’t mean that you should. Without substantial assets, insurance is a financial tool to protect you from potential ruin. When your finances are in good shape and you’re on the path to FI, you have the flexibility to choose the insurance you actually need and what you can “self-insure” with your own money. With insurance, the guiding question you need to ask is, “If something terrible happens to this person or this item, how will it affect me or my family’s life?” How you answer that question will determine whether the added cost of insurance is worth the expense. The further you are on the path to financial independence, the less you need to rely on insurance. The ultimate goal is for you to have enough in an emergency fund or savings to cover the small stuff and let your insurance policies cover the big stuff that would cause catastrophe for you or your family.

Controlling Insurance Costs

Besides cutting out insurance entirely on the small items you can afford to cover on your own, another method to reduce insurance costs is to raise your deductible. But that isn’t without risk. As mentioned previously, the higher your policy’s deductible is, the lower the cost of the premium will be. With a healthy emergency fund, you can afford to take on the increased risk of paying more out of pocket when something bad happens. Since insurance is a financial tool, it’s important to understand the trade-offs you make when choosing a higher deductible. Although it is impossible to predict when you might need to make a claim on your insurance policy, you can use the likelihood of an event occurring in a break-even analysis to evaluate if raising your deductible makes financial sense.

Raise Your Deductible, Lower Your Premium

For example, if you have a $100 deductible with your auto insurance and raise it to $1000, you will pay $900 more in the event of an accident. Next, you’ll need to know how much raising the deductible will lower your premium. If your premiums are reduced by $100 a year, it will take nine years to break even. However, if your premiums go down $450 a year, you break even in just two years and will be $900 ahead for every two years more that you don’t have an accident. What is the likelihood you end up in an accident resulting in more than $1000 worth of damage in the next two years? And how about the next nine years? If it takes just two years to break even, raising the deductible will probably save you money. But if it takes nine years to break even, it may not be worthwhile.

Comparison Shop

Insurance policy rates are based on a variety of factors. Revisit your policy at least once a year to determine if you are still getting the best deal. Look for discounts through any professional associations that you belong to. Also, check with any alumni groups for special discounts. However, just because a company offers you a discount does not mean that you will get the best overall ate through that company. You still need to look at your options. It is best to look at policies with an independent agency or platform that can help you find the right policy. Check back once a year to see if you can get a better deal. You may also be able to bundle your home and auto insurance for large savings. Check with your provider.

Homeowners Insurance

There are a few types of insurance that are truly critical to your financial well-being, homeowners insurance is one of them. This insurance is a financial tool to protect your home and the possessions inside. Premiums for homeowners insurance are based on several factors, the environment you live in, like a floodplain or hurricane zone, what kind of home you own, such as a single-family detached or condominium, and how big and expensive it will be to rebuild. Insurance companies compile this information along with the deductible you’ve selected and your previous insurance history to calculate how much your premium will be. Not all policies are equal, however. Be sure that your policy guarantees “full replacement cost”, meaning that the insurance company will pay what it costs to rebuild your home, not how much you originally paid or what the current fair market resale value might be. If you have commercial properties, then you should work with an independent insurance agent to make sure that you have everything that you need. The lines between personal and commercial coverage are changing, so a professional should look at your particular situation. Those who rent need coverage too. Though the owners of the property will be responsible to insure the dwelling, the belongings inside will not be covered. Renters insurance will help you recover the value of your possessions in the event of a disaster. The great news is that renters insurance is extremely affordable. Related: How to Find the Best Homeowners Insurance Policy

Auto Insurance 

If own a car, you know auto insurance is a financial tool you are required to have.  Even if it wasn’t required, this isn’t an area where you want to try to skip out of because not having it can cost you dearly. There are two elements to every auto insurance policy: liability and property damage. That is to say, how much you are protecting those in your car the vehicle you may get into an accident with, and how much you are protecting your own vehicle.

Liability

Do not go without liability insurance. It is mandatory. Why? While the state may allow you to take risks with your own property, it won’t allow you to put other people at risk. This policy insures you for any damages your vehicle does to another person’s car or property, and for any medical expenses incurred by others from the accident in which you are found to be at fault. Having an auto insurance policy with adequate liability limits is critical to protecting your finances. You might be able to cover the costs of an average fender bender, but what if the accident injures someone so badly that they spend months in the hospital?  The medical bills could be astronomical. And if the accident is your fault, you will be personally liable. You cannot afford to take this kind of risk.

Property Damage

On the flip side, the property damage portion of your  insurance policy covers the damage to your own vehicle. Whether you include collision insurance for your vehicle will depend on your individual circumstances. The value of your vehicle, your personal financial situation, how reliant you are on your vehicle, and your level of risk tolerance should all be considered when deciding on keeping collision or letting it go. If you have an auto loan, your lender likely requires comprehensive and collision insurance to protect them from financial loss. But once the vehicle has been paid off, the decision becomes yours. Yet another money-saving reason to pay off your car! Related: How to Shop for  Car Insurance 

Health Insurance

Much like auto liability, health insurance is another type of insurance you shouldn’t try to go without. With the ever-rising cost of medical care, not having health insurance puts both your finances and health at great risk. Health insurance is the financial tool that can save you millions of dollars. According to the Consumer Financial Protection Bureau, one in five credit reports in the US have a medical collection, and nearly half of all collections in the US is medical debt. Medical debt is ruining American’s financial lives.  Unfortunately, health insurance is also the most complex and difficult to understand. Trying to narrow down complicated policies to the options that are best for you and your family is often a time-consuming and confusing task. There are several options for obtaining health insurance. Many will choose a plan offered through their employer, others will select a plan available from their state’s health insurance exchange, and some will opt to pay for their own plan.

Lowering Your Health Insurance Premiums

Depending on how you get your health insurance coverage, the cost of your premium may end up being a significant amount of your monthly budget. Similar to auto insurance, there are steps you can take to reduce the cost of your health insurance premiums. You can either:
  • Raise your deductible
  • Raise your out-of-pocket limit
Related: Choosing Your Health Insurance: A Guide For Open Enrollment  When reviewing your policy for your next renewal year, determine how changing each of these variables will impact your monthly premiums, and possibly save you money. Those who can cover the potentially higher deductibles and/or out-of-pocket costs with savings should be able to reduce their premiums. The more risk-tolerant you are, the more you can save.

Health Savings Accounts

One benefit of selecting a high deductible health insurance plan is that you become eligible for a Health Savings Account (HSA). An HSA is a tax-advantaged savings account. With this account, you are allowed to set aside pre-tax dollars to pay for qualified medical expenses.  The money within an HSA grows and compounds. Earnings are not subject to tax, and withdrawals are not taxed when used to reimburse any qualifying medical expenses. Though HSA funds cannot usually be used to pay health plan premiums, they can be used for deductibles, copayments, coinsurance, and healthcare-related expenses. It’s also good to know you are not required to request reimbursement at the time the expense is incurred. Those who can cover the costs out-of-pocket as they happen may continue to allow the funds within their HSA account to grow tax-free before requesting reimbursement. Alternatively, it may be saved for a major medical expense in the future.

Other Insurance Policies to Consider

Depending on your circumstances, there may be other types of insurance you will want to consider. These are not mandatory, but these types of insurance as financial tools should be evaluated on a case-by-case basis.

Disability

Disability insurance replaces your income in the event you are injured and cannot work. When others rely on your income to survive or you are a single earner, you’ll want to make sure the bills can still be paid when you cannot work. Once you have established a three to six-month emergency fund, a short-term disability plan may not be needed. But what if an injury prevents you from working at all? Long-term disability insurance provides you with an income when you can’t work anymore because of injury or illness. One of the best places to obtain long-term disability insurance is through your employer. If not offered, shop around for quotes and coverage details using an insurance aggregator, like PolicyGenius. Long-term disability insurance need not replace 100% of your income because of all the deductions that currently come out of your paycheck. It’s another good reason to know what your monthly expenses are, as it’s only that amount of coverage you need a policy for. Related: Disability Insurance: The Most Important Insurance Most People Don’t Buy

Long-term Care

Long-term care insurance pays for nursing homes, assisted care facilities, and in-home care as you age. General advice regarding long-term care insurance is to wait until the age of 60 to decide. The cost of long-term care insurance and the various types of care it pays for have all sky-rocketed in recent years. A plan to pay for your long-term care as you age should be a part of your financial plan.

Life Insurance

The purpose of life insurance is to protect family and dependents when someone passes away. Life insurance helps ensure surviving members of the family are not subjected to the stress of financial hardship. The policy coverage allows for the survivors to get by long enough to where they can earn income and begin supporting themselves, or perhaps even survive indefinitely on the value of the policy. Life insurance can also cover any additional expenses that may be incurred by someone’s passing. A widow or widower may suddenly find that they need to pay for additional childcare or help around the house. Who will take over all the tasks that the deceased had responsibility for? A surviving spouse may wish to reduce their own working hours to take on some of those tasks. Life insurance can help pay for these needs and changes.

Types of Life Insurance

When beginning to research life insurance, it may seem like there are a vast number of options to choose from, but in reality, there are mainly just two kinds:
  •     Whole–an often complex combination of insurance and investment where a portion of the premiums paid accrue and earn interest.
  •     Term–set monthly premiums are paid for a specific term, or number of years. At the end of the term, coverage ends.

Whole Life

While whole life insurance sounds like a great option since your premiums are invested, it’s not ideal. Investing your money is great, stick to simple and easy-to-understand investments with good returns. The ideal investments for wealth creation are stocks, bonds, and real estate. In contrast, insurance is designed for protection from risk. Whole life insurance is an investment product that is frequently complicated, fee-heavy, and has low-returns. It does a poor job at both wealth creation and risk protection. Term life insurance policies are almost always a better deal mathematically. Listen: Whole Life Insurance 

Term Life

With a term life insurance policy, you will select the amount of coverage and the length of time you would like coverage. Both factors will determine your monthly premium. If you were to pass away during the term of coverage, your beneficiaries will receive a death benefit in the amount of coverage you selected. However, if the end of the term arrives and you are still alive, coverage ends. You owe nothing more, and the insurance company owes nothing to you. Life insurance is not a policy you need for the rest of your life. Where are you on your path to FI and how much longer do you plan to work? You may only need life insurance during your working years. Once you reach FI, your investments will meet the annual expenses of your survivors. Being at FI is the equivalent of being self-insured. However, those reliant upon employer-sponsored pension plans may want to consider additional years of term life insurance for the individual who earned the pension or opt to take the pension survivor’s benefit, if one is available.

Find the Best Rates on Term Life Insurance in Under 5 Minutes

Related: Get The Best Price On Life Insurance With Policygenius

Umbrella Insurance

Unfortunately, in today’s day and age, lawsuits are sometimes seen as easy money-making opportunities. As your assets and net worth grow, you must take additional steps to protect them. Umbrella insurance picks up where other policies stop and covers you for a much greater amount. With policies that often start at one million dollars and go up from there, umbrella insurance provides coverage for high-net-worth individuals or those who expect to have a high-net-worth one day.  Premiums tend to be inexpensive. If someone tries to sue you, you’ll also have the added benefit of the insurance company’s legal team working to protect the money they could have to pay out under your umbrella policy.

The Bottom Line

No one enjoys paying insurance premiums. It can feel like throwing money out the window. With some types of insurance, you rarely make a claim or see any rewards after years and years of premium payments. That’s why it’s good to remember insurance is a financial tool. When the unthinkable or unexpected occurs, and suddenly you need insurance, you’ll be grateful to have it.

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