The Most Common Pitfall I See in Personal Finance

Among personal finance issues, insurance is perhaps the most difficult subject to address because it forces us to think about the unknown: in particular, our own mortality and sense of invincibility. Bad things happen to other people—not me. (For more, see: How Exactly Does Life Insurance Work?)

And because insurance is about protecting against a future unknown, it’s difficult to determine or calculate how much protection you and your family will actually need. Then there’s the issue of estimating how long will you need the protection. What is known for certain is that you will pay premiums month after month and year after year. What is unknown and uncertain is whether the event you’re insuring against will ever occur.

For example, you pay your auto insurance premiums every month. Let’s assume your average annual auto insurance premium is $1,000 and that you’ve paid it diligently for the last 20 years and never made a claim. That’s $20,000 of auto insurance premiums gone.  

What could you have done with that $20,000? You could have done all sort of things with that money—invested it toward your retirement, added it to your emergency fund, spent it on a nice vacation or used it to fund college. The list goes on.

On one hand, you may perceive this as a waste of financial resources. But what if you have to make a claim for a serious accident in which you are considered at fault, which involved totaling your car and that of another driver? Add in some medical expenses and then a little compensation for pain and suffering.

A rule of thumb for a pain and suffering settlement in this case is about one to five times or more the cost of medical bills and lost income. The settlement for major accidents could be worth $50,000-$100,000. (In California, for example, the compensatory median award for personal injury trials is $150,000—and many of them are auto related).

In our example above, you’ve paid $20,000 in premiums, and your insurance company settled your claim for $100,000. Your policy provided five times more in benefits than you paid in premiums. In other words, you paid $0.20 on the dollar for the benefit your policy paid out after the accident.

Would you consider yourself lucky for paying pennies on the dollar for an event that could be financially catastrophic?

Now to the question that comes up frequently: How much insurance is the right amount of insurance? My approach towards insurance is that the right amount should protect against catastrophic events. Please note that others may disagree with this and that’s okay. There is no one absolute right way to determine the amount of insurance that’s right for you. Certified Financial Planners and insurance pros can run various calculations and each has validity. (For related reading, see: Is Insurance Through Work Enough?)

The real work (or art, if you will) comes in balancing a client’s tolerance for risk, their financial capacity for handling and managing risk, and their financial goals and cash flow. Together, these factors help determine the level of risk someone should retain versus paying the premiums. With high deductible policies you can lower your premium payments. With lower deductibles, you pay higher premiums. (For related reading, see: Don't Let Risk Ruin a Great Financial Plan.) 

Let me caution you that whatever you do, it’s dangerous to look at insurance as just another expense the way too many people do. It’s also dangerous to settle for purchasing the minimum coverage amounts. I believe that insurance, when chosen appropriately, is a reasonably-priced hedge against unknown events that could potentially bankrupt you. In many ways insurance is nothing more than purchasing financial peace of mind.