What is insurance?
Insurance is the transfer of risks of large accidental financial loss from you (the insured) to the insurance company (the insurer) for an affordable premium.
Risk: Harmful or negative events that may or may not occur. Without risks, there is no need for insurance.
Financial loss: The loss must be translated to and quantifiable in dollar terms. The insurance company will not rebuild your burnt-down house, but they can give you the money to rebuild.
Accidental loss: The loss must be accidental and out of the control of the insured or the beneficiary. If the loss is regular or controllable, it cannot be insured.
Large loss: If the potential loss is small, you may be better off keeping the premium and taking the risk. "Large" is relative. If you are poor, a $10,000 loss is large. If you are a multi-billionaire, a $1 million loss may "disappear" into a rounding error.
Affordable Premium: If the premium is so high compared to the cost of the insured event, you may be better off keeping the premium and taking the risk.
What types of insurance are there?
Health insurance: Health insurance covers health risks and makes payments for health problems and associated medical expenses. Many countries have national health insurance programs, but there are usually exemptions ("gaps") that private insurance can cover ("gap coverage").
Disability insurance: Sometimes known as "income insurance". It covers the risk of becoming disabled and unable to work, and usually pays a percentage of your income. "Same occupation" disability insurance will pay you if you lose the ability to work in your current occupation. "Any occupation" disability insurance, however, will only pay you when you lose the ability to work in any occupation. "Same occupation" insurance will protect you better than "any occupation" insurance, but it is also more expensive.
Life insurance: Life insurance covers the risk of death, and will pay your family (or your chosen beneficiary) the insured sum upon your death. The amount of coverage should cover burial and funeral expenses, and, if your family is dependent on your income, provide financial support for your family. If you have no financial dependents, you do not need life insurance. Life insurance may be classified into temporary or permanent insurance. Temporary (term) insurance are, usually, the cheaper and better choice.
Automobile insurance: Also known as "vehicle insurance" or "car insurance". It covers the risks involving your car, and may include damages you caused (third-party liability), damages to your car (collision), and loss of your car and its contents (theft). Third-party liability coverage are compulsory in some countries (such as Taiwan), and I recommend them even if they aren't compulsory (in case you ever crash into a Ferrari or a super-expensive house).
Property insurance: There are insurance coverage for the building (your home) and contents (your furniture and other possessions). There also specialized coverage for damages caused by fire, earthquake, and flood.
Liability insurance: Professional liability insurance are usually advisable for professionals such as doctors, and they cover risks such as malpractice lawsuits. Given that we live in an increasingly litigious society, some professionals will need liability insurance. Liability insurance may also be available for small businesses and the products you sell.
Travel insurance: Travel insurance may cover risks such as medical emergencies, lost luggage, travel delays, etc. Some credit cards, such as the American Express Blue Cash, provide travel insurance for free if you pay with your card.
First steps to buying insurance coverage?
1. Assess and prioritize your risks. What risks do you have? Which risks do you most need protection from? What risks do you already have sufficient protection for?
For example, if you work in a company that provides health and dental plans, have 3 young children, and are the sole financial provider of your household, you may want to buy life insurance first. National health insurance, company's health plans, and worker's compensation from your company may provide sufficient coverage for your health and potential job-related disability.
2. Review your budget and figure out how much insurance you can afford. If you are young, have a fair amount of net worth, and are saving and investing 50% of your gross income, you can probably afford to buy more insurance if you need them. If you don't have much room in your budget for insurance, you need to identify what are your highest priority risks and get insurance for those first.
How much insurance coverage do I need?
There are a few method of determining the level of coverage you need:
1. Expected cost: How much will the expect costs be if the insured risk events occur? This method applies for medical insurance and liability insurance.
2. Replacement cost: How much will it cost to replace what's been insured? This method applies for automobile insurance and property insurance. Don't forget to take into consideration inflation or appreciation from your purchase cost!
3. Discounted cash flow (DCF): How much will it cost to replace your future cash flow? This method applies for life insurance and disability insurance. When calculating how much life insurance coverage you need, you should determine how much you expected to earn in the future, then use DCF to calculate how much those future earnings would equal in present day dollars. If you died today, this amount will allow your financial dependents to live as if you are still alive earning money.
Bonus: How do insurance companies earn money?
From your perspective, it appears that the insurance company took your large risk for a relatively small premium. The insurance company, however, have many other people similar to you buying similar insurance policies (let's just say that you and those people belong to the same "group"). The risk that individuals in the group will suffer from the insured event will approximate the probability of that event occurring (calculated by an actuary). The insurance company is basically taking your premium and spreading your risk with the entire group. In return, the insurance company receives a small portion of the premium for managing your risks.
References:
- Wikipedia:
- Get Rich Slowly:
- A Brief Introduction to Insurance.
- Finding Affordable Health Insurance When You're On Your Own.
- The Disability Insurance Maze: How to Select and Purchase a Policy.
- The Simple Dollar: Interesting Insights Into Life Insurance from an Actuary - How He Would Buy Life Insurance.
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