Last Updated: September 12, 2011
On August 23, 2011 the East Coast of the United States was rocked by a 5.8 magnitude earthquake. It was the most significant earthquake on the East Coast since 1944, according to U.S. News and World Report. As things began to return to normal, Hurricane Irene made landfall in the Outer Banks of North Carolina and proceeded northward along the eastern seaboard. Only Mother Nature knows what will come next.
These two significant events created a whirlwind of insurance claims and prompted many to review and reconsider their insurance portfolios. This article reviews the basics of insurance so you can determine what can be insured, what should be insured, and what can (or must) remain uninsured.
To understand insurance we must first understand risk. Risk is best defined as the chance or uncertainty of loss. Examples include the risk of physical injury when participating in sporting events and the risk of financial loss when investing hard earned dollars in the stock market. You make important, and sometimes subconscious, decisions about managing risk on a daily basis. Developing a formal plan to address the risk of financial loss is a crucial component of the financial planning process.
There are four options to consider when addressing risk — the uncertainty of loss — in the planning process. A risk can be avoided, controlled, retained, or transferred.
Some risks can be avoided, although that is not always practical. For example, death as a result of sky-diving and the corresponding financial loss to the family is one risk most of us avoid. The risk of financial loss due to your house catching fire is one that cannot be avoided. We all need a place to live, and the risk of financial loss due to fire is nearly impossible to avoid.
While we cannot completely avoid the risk of financial loss due to a fire, there are certain steps we can take to control the risk. Having sprinklers installed in your home, a fire extinguisher in the kitchen, and properly disposing of cigarette butts are all examples of controlling risk. Many of the risks we encounter on a daily basis can be controlled or mitigated.
A third option for addressing risk of financial loss is to retain the risk. Our ability to earn an income is one of our greatest financial assets and loss of that ability one of our greatest risks. Yet many smart, hardworking people do not have a rainy day fund or disability income insurance through work or via a personal policy. They say “It will never happen to me” and in many instances they are right. The point is those without disability insurance and those who spend every dollar they earn make a decision to retain the risk of financial loss in the event that they are unable to earn an income due to illness, injury or sickness.
The fourth and final option to address risk is to transfer it to another party. Although there are a number of ways to transfer risk, the most common and the one addressed in this checklist is to transfer the risk of financial loss to an insurance carrier via an insurance policy/contract. The insured pays a stipulated premium to the carrier in exchange for policy benefits by way of the insurance policy as a result of death, disability, sickness/injury/illness, fire, theft, automobile accident, or due to a professional’s negligence. Having appropriate levels of insurance transfers the risk of financial loss to an insurance company. However, keep in mind not all risks are insurable.
A number of conditions must be met for the risk to be an insurable risk. The risk must be a “pure risk” — a risk that bears only the possibility of a financial loss. Speculative risks involving both the possibility of loss and gain cannot be transferred via an insurance policy.
In addition, the law of large numbers, which states losses become increasingly predictable as the amount of data used to create the statistics increases, must apply. It is the law of large numbers that allows insurance companies to charge affordable premiums. Insurance companies must have sufficient data to conclude some insureds will experience a financial loss and many will not. The insurance company uses premiums collected from every insured to pay policy benefits to the few who suffered a loss. The carrier must do so in such a way that the carrier remains compliant with various rules and regulations and is able to generate a profit. If the law of large numbers does not apply, the risk is not transferable by way of an insurance policy, or the premium to do so would be much too high.
Finally, there must be an insurable interest for a carrier to issue a policy. Before one can benefit from an insurance policy, one must demonstrate the possibility of financial loss. Children, by way of example, have an insurable interest in their parents. If one or both parents was to die, the children would experience a financial hardship. Thus insurable interest exists and the children can be beneficiaries of a life insurance policy on their parents. The individual who sits in the cubicle next to the deceased parent has no financial interest in the parent’s death and thus they cannot benefit from insurance on the parent.
All of us are exposed to financial risk of loss on any number of levels. It is important to identify those exposures and to consider your options to address the risk of financial loss. Granted, investments make a better conversation at cocktail parties than insurance, but controlling the risk of financial loss is part of the foundation of financial planning. A financial planner knowledgeable in insurance planning can help you identify areas of potential concern and develop a plan to reduce the risk of financial loss.