Understanding your insurance needs

What is Insurance?

Insurance is a contract represented by a policy, in which a policyholder (you) receives financial protection or reimbursement against losses from an insurance company. The company pools clients’ risks to make payments more affordable for the insured. There are a number of types of insurances; here are a few:- 

Types of Insurance Policies:

• Life Insurance: Provides a payout to beneficiaries upon the policyholder’s death.

• Health Insurance: Covers medical expenses and treatments.

• Critical Illness Insurance: provides a lump sum benefit if you are diagnosed with one of the illnesses covered by the policy.

• Homeowners Insurance: Protects against property damage or loss due to events like fire, theft, or natural disasters.

• Auto Insurance: Covers damages related to accidents, theft, or vandalism involving your vehicle.

What insurances do I really need?

I often speak to persons who feel overwhelmed by insurance agents pitching many complicated products and leave those meetings more confused about their situation than when they started off. The agent follows up aggressively until the client ‘caves in’ and purchases a policy that they pay for the rest of their lives. Sounds like you? There are many others in your situation and I hope this article sheds some light on insurance products and how to approach the insurance market. 

Think of insurance as risk protection for pure risks. These are risk that involve a possibility of loss, only (as opposed to investment risk where there is a possibility of a gain). These are split into 1) Personal (life/ health), 2) Property and 3) Liability to other persons. 

By default, we all live with these risks and must ascertain if we are able to support the potential loss- that is do we have sufficient resources to incur the loss without materially affecting our standard of living or should we seek to control the risk or finance the risk through insurance.  Controlling the risk means avoiding the risk (e.g. dont engage in dangerous sports to avoid accident), use separation strategies (e.g. spouses travel on different flights), or use prevention strategies (like exercising and eating healthy to avoid premature death). As you can tell, controlling the risk, does not mean the risk would not occur so we may chose to finance the risk through the insurance market which works on the laws of large numbers. You pool your risk with a large population and pay a premium in return for a payout if the specified risk event occurs. The decision on whether or not to insure a risk is a personal choice and by default, if we don’t chose to finance the risk, we must live with the consequences should the risk event occur.  There is no such thing as ‘self-insurance’, we simply choose not to finance the risk because we implicitly assume that the loss associated with the risk would not materially affect our standard of living. In reality, many persons choose not to finance a risk due to lack of knowledge of insurance options, a tight budget, or misaligned spending.

What are these risks?

In life, you accumulate assets and also earn income that you and others depend on. When you accumulate those assets like cars, homes, jewelry, contents of your home, etc. you likely increase your standard of living and enjoyment. One day you will need to replace your car, your home will need repairs, etc. and you can budget for those known future expenses. You also earn income from your job that you use to pay bills and take care of your family. You budget for those expenses knowing that you have your income coming in every month. You also put aside monies for retirement to at least maintain your standard of living in retirement. These are all known or can be reasonably estimated in advance. But, what happens if an unlikely event occurs and you lose your home to a fire, or a major car accident occurs? You are not expected to have enough money to buy a new car or home. You should have asset insurance to cover these low probability events. If you also lose your job due to illness or an accident that affects your ability to work, you likely still have those bills to pay and a family to take care of.  You should have life, critical illness and disability insurance to cover these low probability events that could affect your income as well. If someone is severely injured or dies because of your negligence or due to accident (e.g. speeding), you must have liability insurance to cover those potential large losses.

No one size fits all

Like the investment market, insurance products do not come in a one-size fits all package. The type of risk protection you need depends on the assets you accumulated, your income levels & wealth, life-stage, and lifestyle. While I cannot give exact figures & advice without knowing your situation, I can say that we all likely need 3 types of insurance throughout our lives- asset insurance, health insurance & critical illness insurance. Some of you may be surprised life insurance isn’t on the list. If you have dependents, that is persons financially dependent on you to meet their needs like your children, elderly parents, or spouse, then you should definitely consider having insurance to help these persons either transition to life without you or provide for them financially in such a way that they are not worse off by your absence. Some persons chose not to have children or marry and may not have dependents so life insurance may not be a need. 

As you also may be able to tell, the types and amount of insurance coverage you need changes throughout your lifetime. You should review your risk situation when life circumstances change (much like you revisit your investment goals when life circumstances change). Some examples are marriage, birth of a child, divorce, children becoming independent, retirement, death of a spouse. 

Insurance as a wealth building tool

Of course, insurance is a risk management tool, but to the angst of insurance firms, persons use life insurance specifically as a means to pass on more wealth to their next generation than their pure insurance needs would require. This involves paying a higher premium for potentially higher payouts and so there is an incentive for families not to engage in having excess insurance (the issue of being under-insured is much more prevalent than having too much insurance). These persons use an expense approach to estimating life insurance needs as opposed to the income or human capital approach. (If you would like to learn more about how to determine appropriate insurance coverage, let me know via email or comment and I can produce some more reading materials). 

Some very wealthy families, may not need certain types of insurance because the materiality of the potential loss is very low compared to the average family. Before you chose to ‘self-insure’, speak to a financial advisor.  

A Special Note on Life insurance

The topic of life insurance is broad so I will just touch briefly on it here. There are mainly two types of life insurance policies. 

1) Term Life policies- these are pure life insurance policies without savings/investment features. 

2) Insurance policies with a savings/investment feature. E.g. whole life and universal life insurance policies. 

The insurance premium you pay is made of 3 components- pure premium + insurance company service cost (cost of administration, etc.) + profit. If the insurance company charges a premium such that the present value of expected benefits to beneficiaries is equal to the present value of revenues received by the insurance company then this is the pure premium. Without the fanciful language, it is the amount you would pay to insure against a risk if the insurance company made no profits and had no running costs to cover.

All this was necessary to explain that if there are additional features, such as payback of premiums, cash value, dividends, endowments,  you are likely paying a higher premium to account for the cost of those features. So one might ask, should I invest in term life policies vs. the policies that have a saving/investment component?  Well the answer depends on how effectively you can management your savings and investments vs the insurance firm managing your savings/investments. 

In my research, I would conclude the average person has superior investment options available to them in the Trinidad and Tobago marketplace than the typical insurer provides. So why do so many persons buy non-term policies? Firstly, insurance agents are paid higher commissions on non-term policies and so would push those products more. And secondly, if someone does not have the discipline for the investment route, then forced savings may help them (although an automatic direct debit into an investment account would accomplish the same). If you are an insurance agent reading this and have superior investment options, please do reach out. 

I hope is article was helpful for you and your family.