I have heard it before, ‘Insurance is a scam. I pay for it every month and yet I may never even use it!’ Buying insurance can often seem like an “extra” or a “nice to have” type of expense. After all, the only time most insurance pays is if something bad happens, right?
But insurance, when used the right way, is one of the most important underpinnings of your financial life. This is demonstrated by simply understanding the basic definition of insurance: a legal contract between the policyholder (i.e., you) and the issuer (the insurance company) that obligates the issuer to provide a financial benefit in exchange for the payment of premiums (your payments to the issuer) by the policyholder. In short, insurance is there is protect you from a financial catastrophe. A policy can provide money to pay for losses that occur with personal property, your car, your house, and even your personal liability for something that happens to someone else or their property.
Why is this important? Because unforeseen circumstances can generate financial and/or legal liabilities that can wipe out years of savings and investment. For example, suppose someone trips on the front steps, coming into your house. In a freakish turn of events, they fall and hit their head, receiving a serious brain injury. Because the injury occurred on your property, you could be held legally liable, requiring you to pay for medical expenses that could run into hundreds of thousands of dollars—not to mention the likelihood of associated legal fees. Without insurance, you’d be forced to come up with the money to pay all these damages from whatever resources you have. But the right kind of insurance policy would provide money for all these expenses, not to mention putting the insurance company’s attorneys on your side of the table in the event of a lawsuit.
The basic concept of insurance is that it shifts financial and other liabilities from the policyholder to the issuer. This is a very useful financial tool in several circumstances. Let’s take a look at a few types of insurance that can be especially important for young professionals who are in the early years of their career.
1. Renter’s insurance. For many young people who are just starting out, renting a place to live, rather than buying a house, is a smart financial move. Renting allows you to shift most of the expenses of residential upkeep onto your landlord while you build up your savings for a down payment on a place of your own. But your stuff—your flat-screen TV, furniture, artwork, jewelry, and everything else of value in your apartment—would not be insured in the event of theft or disaster unless you have a renter’s insurance policy. In fact, many landlords are requiring tenants to show evidence of a renter’s policy as a condition of approval for residence. Renter’s insurance policies are low cost and provide excellent protection for an unexpected incident.
2. Auto insurance. Anyone who owns a vehicle is probably somewhat familiar with auto insurance, since providing proof of insurance is required in most states in order to register a vehicle in your name. There are four basic components of auto insurance: 1) liability, 2) comprehensive, 3) collision coverage, and 4) personal injury protection (PIP). A policy that provides liability coverage only pays benefits for damage or injury to others (usually excluding passengers in your car, that is where PIP provides protection) that is legally judged to be your fault. Most states require all vehicles to carry liability insurance. Comprehensive coverage pays for damage or replacement costs for your vehicle when there isn’t an accident—through theft or natural disaster, for example. Collision, as the name implies, covers damage to your car caused by any accident, whether your fault or someone else’s (an uninsured driver, for example). Most lenders will require you to carry all four types of coverage as a condition of providing a car loan. Most policies stipulate limits to the amount of coverage provided in all four categories. Obviously, the higher the limits, the more expensive the policy. Many states establish minimum amounts of coverage that must be offered.
3. Homeowner’s insurance. When you buy a home using a mortgage, the mortgage lender will require you to provide proof of homeowner’s insurance but we recommend homeowner’s insurance whether it is required or not. A homeowner’s policy provides payment for damages to the home and its contents or personal injury resulting from fire or natural disaster (with the exception of earthquakes and floods, which we’ll discuss in a moment). Most policies also extend coverage to outbuildings and other structures such as detached garages, toolsheds, fences, and such. Many policies will also cover the cost of temporary housing if you must vacate your home while repairs are underway. Personal injury to non-residents of the home (such as that described in the above example) is also typically a covered expense. Policies may vary as to whether they provide for actual replacement cost or cash value. This is an important distinction. Suppose the roof on your house is ten years old, and a tree falls on it. A replacement cost policy will pay based on what roof repairs cost today; a cash value policy will deduct ten years’ worth of depreciation from the repair cost before paying. In other words, while replacement value policies may cost a bit more, it’s often well worth it when you need to file a claim.
Floods and earthquakes are two hazards that are excluded from most standard homeowner’s policies. If your home is located in a federally recognized flood plain or other area prone to flooding, you will need to obtain coverage through the National Flood Insurance Program. You can look up your property using the Federal Emergency Management Agency’s (FEMA’s) online tool. If you live in an area prone to earthquakes, you will need to obtain a separate earthquake policy or a special endorsement to your homeowner’s policy to cover such losses. As I mentioned, insurance is there to cover catastrophic loss and if you were to lose your home (for most individuals their largest asset) in a fire, flood or earthquake, could you afford to rebuild without insurance? I highly recommend you consider your homeowner’s insurance policy carefully to ensure you coverage is aligned with the possible severity of loss.
4. Umbrella liability insurance. Sometimes damages and injuries occur that can expose you to financial liability greater than the coverage limits on your homeowner’s, auto, or other insurance policies. Let’s say, for example, that you fall asleep while driving on a busy freeway, resulting in a 10-car pileup. The cost for the damages to the other vehicles and the injuries to their occupants can easily overwhelm the limits of coverage on your auto policy; nevertheless, if you are judged at fault for the accident, you are liable for all those expenses (and don’t forget the lawyers). As the name suggests, an umbrella policy is designed to “spread out” over all your other coverages, picking up where they leave off. Because umbrella policies only come into play when other coverage is exhausted, they are not that expensive to own. And yet, they can offer significant peace of mind in the event that the really unexpected happens.
5. Deductibles. One final term that you will often hear in the context of insurance is “deductible.” Whether referring to health insurance (not covered in this article), car insurance, homeowner’s insurance, or any other type, a deductible is the amount you must pay for any claim before the insurance company becomes responsible. So, if your comprehensive and collision policy on your car carries a $500 deductible (a typical deductible for many car lenders), the first $500 from any claim is your responsibility. After that, the insurance company begins paying. Homeowner’s policies may have a fixed deductible ($1,000–2,000) or a percentage deductible, based on the cost of the home. So, if your home is covered at a value of $500,000 and you have a 1% deductible, the first $5,000 of any covered claim is your responsibility. Generally, a higher deductible will result in a lower premium.
At Griffin Black, we want you to be well informed in all your financial choices. To learn more, click here to read our article, “Decluttering Your Bottom Line: Financial Spring Cleaning.”