Don’t Risk a lot for a Little (Why we have Insurance)

Why do we have (or should have) insurance?  There are many answers to this question, but, unfortunately, not everyone answers the question correctly.

Some folks might say I have insurance because the state requires certain limits for my auto policy. Some folks might say I have insurance so that my spouse can live like a king or queen if I die, or others may say I have insurance because someone sold a policy to me.

Insurance has many functions in our financial puzzle: income replacement, liability protection, estate planning purposes, and protection. Understanding the right types of policies and amounts of coverage is critical, not only, for financial success but also for a good night’s sleep.

Income Replacement

The need to replace income comes in two forms: income replacement for the loss of life (loss of earnings) and income replacement due to disability (also loss of earnings). These two needs can be solved by purchasing life and disability insurance, but the problem lies in knowing how much life insurance is enough, as well as, navigating the intricacies of disability insurance.

A simple term life policy is the answer in most cases to cover the life insurance need, but, unfortunately, using a simple formula (such as 10 times earnings) may not get you to proper life insurance amount.  A holistic, big picture analysis is needed to capture all the factors involved with life insurance planning.  The answer doesn’t get solved by over-purchasing life insurance either.  If you have too much life insurance it can be inefficient and the equivalent of buying a lottery ticket.  Remember the ultimate goal of life insurance (in most cases) is to replace the income of the decedent….not to make the beneficiary wealthy.

Disability is a difficult type of insurance policy to understand, especially if you are purchasing an individual (not a group) policy.  Understanding the vernacular can be a challenge.  Waiting periods, occupation classes, payment periods, and other lingo can certainly make our head’s spin when it comes to evaluating a policy.  A careful, unbiased review is certainly needed to find the right policy.

Liability Protection

It’s important we protect our assets. One way to achieve that goal is by covering ourselves against liabilities.  For example, driving a car exposes us to a potential liability. If we cause an accident that produces $100k of damages, we need to cover ourselves against that potential liability.  We do that (or should do that) through insurance.

The old insurance axiom of “don’t risk a lot for a little” rings true here.  Having the proper amount of auto insurance (as well as other property and casualty insurance) is critical…..not the minimum limits the state tells you to carry!  Remember, if you cause an auto accident and your insurance doesn’t cover the damages, you could be party to a personal lawsuit, which could deplete your hard earned assets.  We should cover our potential exposures through insurance.

Estate Planning

There are a few instances where insurance can come into play for estate planning purposes.  The most common is to cover an estate liquidity issue. Estate tax liquidity refers to the cash needed to cover estate taxes.  For ex, someone who owns a highly valuable asset (such as a family farm) may not have the cash to cover the estate tax liability.

Here are some numbers:

Family Farm = $10M

Additional Assets $250,000

Estate Tax Exclusion = $5.25M

Taxable Estate = $5M

Tax Due = $2M

So, in this example, a family farmer may have a valuable piece of property in which they farm for a living.  If the owner dies, the estate could owe as much as $2M in estate taxes.  I don’t know too many farmers with $2M sitting around ready to pay estate taxes.  While the property is valuable, the family may not want to sell the property just to cover the taxes due.  In some unfortunate cases, it may be the only choice, but having a life insurance policy in place to cover the $2M hit is certainly a possibility.  This tactic would then preserve the family farm.

Protecting Property

We have all worked hard for the things we own.  Our home, cars, jewelry, and other personal possessions are valuable to us.  We must protect them. Again, don’t risk a lot for a little.  It’s much easier to pay $1500 a year for home owners insurance than it is to rebuild the $500k house from scratch.

This type of insurance is in place simply to cover the loss of an asset.  What if you lose your wedding ring? Is it insured?  It should be!  What if a tree fell on your home and car at the same time? Are you covered?  You should be!

Insurance is an important piece of our financial picture, and it’s important to understand what and how your assets  needs to be covered.  Simply using the state minimum requirements is a disaster waiting to happen.  Haplessly buying a policy without understanding the intricacies is risky.

While the above areas of insurance do not cover the entire range of insurance needs and applications, the message is simple: don’t risk a lot for a little!  If you don’t understand insurance (and most people don’t), it is invaluable to work with someone who does.  A fee-only financial planner is great place to start.   The Alliance of Cambridge Advisors (ACA) is a wonderful, not for profit, organization of fee-only financial advisors who can help you understand your  true insurance needs.  You can find a local ACA advisor here.

Disclosure: Troy Von Haefen, CFP(R) is not an attorney and the above information does not constitute legal advice but is written for informational purposes only.


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