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Why buy insurance? To provide protection from financial ruin

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Len Rhodes

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By Len Rhodes

Sunday, April 8, 2018

While at a family get-together the other day, I walked up in the middle of a conversation between two cousins. It seems that the wife of one of the cousins had “just tapped” the bumper on the front passenger side of his pickup truck while backing out the drive way two days before.

The damage was cosmetic, but the bumper would have to be replaced — to the tune of $2,263 — rather than being repaired. I arrived at the point in the conversation where my two cousins were lamenting the high cost of insurance and discussing ways to recoup some of their premiums.

My cousins believed that insurance premium dollars paid to insurance companies were somehow squandered unless you could find a way to get back those dollars through frequent or inflated claims. They agreed that unless you could get back dollar for dollar what you paid in premiums, you were wasting money.

I suggested that you don’t buy insurance with the intention of getting money back. In fact, insurance is the one thing you buy with the hope of never using it. Or you use it every minute of every day. It was clear from their reaction that I must have just grown a third eye. I offered to explain.

There are certain risks associated with engaging in any activity, including ownership. Insurance works by spreading the cost of this risk over a large group of people. This allows individuals to buy affordable protection against a financial catastrophe. Thus, when you buy insurance you buy protection from financial ruin. That’s the purpose of insurance — to protect against financial catastrophe. The money is not wasted if you never make a claim because you’re buying protection. Protection is the product.

Since protection is the product you buy, then you are using your insurance for every minute the policy is in force. Your car, your home, your valuables, your health, your income, essentially anything that you insure is protected. Your car is protected even when you’re not driving it. If someone hits it in the parking lot, you’re covered. If a tree limb falls on it in your driveway, you’re covered.

Understanding what insurance really is, and what it is for, means that you can use a few simple strategies to get the most for your premium dollar.

First, insure only the things that would cause financial hardship should you lose them. You should consider insuring things like your home, car, health, and earnings. For most of us, losing any of these would send a shockwave through our finances.

Second, buy policies with the largest deductible you can afford. You want to insure the big stuff and not sweat the small stuff. Of course, you must draw the line between big stuff and small stuff. Again, you want to buy protection against a financial catastrophe, not to smooth out the everyday bumps of life. If you can pay for it out of pocket without too much financial heartburn, then you probably do not need to insure it.

Recently when shopping for car insurance, I was offered the choice of a $500 deductible or a $1000 deductible on a new policy.

The $1000 deductible was $250 per year cheaper than the $500 deductible on the same policy. Said another way, the extra $500 in protection would cost me $250 per year. That’s extremely expensive insurance. And I could afford to pay the extra $500 out of pocket. I wouldn’t like to, but I could if I had to. And I hope I don’t have to.

Third, buy the broadest coverage you can find. Avoid policies that cover only a very narrow set of circumstances. Buying policies that protect you from a wide range of risk are more cost effective than buying very specific policies.

For example, it is much more cost effective to by a good life insurance policy rather than buying flight insurance. Compare the number of people killed in plane crashes to drunk drivers on our highways each year. It is also much better to buy a major medical policy rather than, for example, cancer insurance. What happens if you get heart disease or diabetes?

Last, be careful when opening your mouth at a family get-together. You may need insurance sooner than you planned.

Len Rhodes is the director of technology, information and operations in the College of Business at East Carolina University.

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