All insurance is a waste of money until it comes time to file a claim. The trick is in determining which insurance is good, protecting you from serious financial harm, and the bad.
When I talk about good and bad insurance I’m not talking about fraud or an insurance company acting in bad faith. What I mean when defining the quality of insurance is the value it brings in protecting against loss.
In most cases, people want the least amount of insurance possible without putting themselves at risk of a financial loss that would destroy them. Auto insurance has a minimum requirement in every state. However, some states allow you to opt out. For example, Arizona allows you to provide a bond, certificate of deposit or deposit cash with the DMV for the minimum coverage levels in lieu of actual insurance. Another example is Virginia where you can opt to register as an uninsured motorist for an annual fee as long as you have a clean driving record.
Lenders require insurance on assets they have as security. There is no insurance requirement for any real estate you own unless the property is mortgaged.
Then we get to life insurance. There are strong feeling when life insurance is discussed, except it isn’t that simple. There are times life insurance products are powerful tools in wealth preservation. All too often life insurance is used incorrectly. We will explore where value exists with life insurance.
Most insurance is neither all-good nor all-bad, though there is more all-bad insurance than you might expect. Most falls somewhere in the middle. To gain the greatest value with the least expense requires a modest understanding of what each type of insurance covers and a modest amount of simple math. That is how you keep your insurance costs low and protection high.
Good and Bad Auto Insurance
We will start with auto insurance since it is practically a requirement if you drive.
State laws require a minimum level of insurance. Auto insurance is highly regulated in each state to protect lenders making auto loans and to protect those injured in an accident.
The issue of good and bad insurance with auto coverage involves the various facets of the policy.
Collision: No state requires collision or comprehensive coverage, but lenders do. If you don’t have a loan on a vehicle you can eliminate this insurance expense.
Should you? There is a very small amount of math required in determining if insurance coverage is worth it.
Value of vehicle: $20,000
Premium per deductible:
$5000: $500 per year
$1,000: $1,250 per year
$500: 2,500 per year
(Keep in mind insurance premiums vary widely between geographic locations, the age of the insured driver and driving record. The above example numbers are not meant to be indicative, but rather instructive.)
First, the most you can lose if you total your vehicle is $20,000. Second, the larger the deductible the lower the premium paid.
Your financial standing plays a role in how much collision coverage you should buy. If you have a seven figure net worth you may choose to forgo collision coverage all together regardless the value of the vehicle. You may have no real choice but to buy lower deductible coverage if you don’t have the resources to pay for a $5,000 deductible or if the lender requires a minimum amount of collision insurance.
I want to look at this from a purely financial viewpoint. A $500 premium for a $5,000 deductible means you will need to have a greater than $5,000 claim every 10 year to come out ahead. Insurance companies are not stupid. They sniff out risk better than a bloodhound. If you have frequent claims it is unlikely the premium would be so low.
A good rule of thumb (though not for everyone) is not to have collision on a vehicle worth less than $5,000. The accountant in the room hasn’t had collision coverage for decades. Since I haven’t had a claim in forever it has been a good deal.
Where the tire meets the pavement is between deductible levels. The premium is $750 per year more for a $1,000 deductible than a $5,000 deductible. When looked at correctly, this means you are paying $750 per year for an additional $4,000 of protection.
See the issue? In just over 5 years the premium pays the entire $4,000 of additional coverage. You either have a lot of accidents or you are better off with the higher deductible.
It gets worse with the $500 deductible. Now you need to file a claim more than once a year for the insurance coverage to pay off.
My example is extreme, but it illustrates nicely how you should calculate the level of insurance you really need.
Comprehensive coverage, if listed separately, should be calculate the same way.
I’m not here to tell you how much insurance you should or should not have. I want you to understand the math so you can make the best consumer choice for you. The simple example above helps you optimize your coverage while keeping premiums as low as possible.
Liability: There are two forms of liability insurance required by most states: bodily injury and property damage. Bodily injury cover someone else’s injuries if you cause the accident; property damage is damage to the other person’s property, such as their vehicle.
Here is where the math goes out the window and risk is the primary concern. Wrongful death gets expensive fast. Same with medical bills if someone is injured. If you cause an accident, even if unavoidable, your liability risk can destroy almost any lifetime of savings. Something as simple as a slick road due to black ice or fog can put you in jeopardy.
The more you have to lose the more liability coverage you will need. Laws differ by state so it is important to have a serious discussion with your insurance agent. They get paid when you buy a policy. Be sure to discuss your situation fully with this person to verify you have adequate coverage and that you are covered for what you think you are. You may even wish to have an umbrella policy in addition to your regular auto insurance.
Liability and collision are the expensive parts of an auto policy. The best way to save money is to have a clean record: no traffic violations or accidents.
Underinsured (UIM) and Uninsured (UM) Motorist: This is the area where price shopping can get people in trouble. Agents can shave a few dollars off the premium to beat the competition by quoting the minimum requirements for UIM and UM. This can be a huge mistake!
UIM and UM are generally pretty cheap. Jacking the coverage to the same level as your liability coverage can be as little as a few dollars per month. You don’t save a lot by skimping on UIM and UM, but you will be surprised what you risk
Why is UIM and UM important? First we need to review who is covered by each area of the policy. Liability coverage protects them. In other words, your liability coverage deals with injuries and damages to someone else. UIM and UM protects you when the other guy has inadequate insurance and is at fault!
What does this mean? The best way is to look at an example.
A highly intoxicated driver runs a stop light and hits your vehicle, killing the intoxicated driver and your significant other in your car. The intoxicated driver is uninsured. Your insurance liability coverage deals with the intoxicated driver’s death and vehicle damage. Like most drivers, you have ample liability coverage so you come out of any litigation with no financial damages since the insurance company paid the claim. The family of the intoxicated driver stands to gain well into the six figures in damages for wrongful death, depending on the state where the accident occurs.
You, however, are covered by your UM because the intoxicated driver in uninsured. Since you have minimal coverage ($25,000 in many states) you may get a claim payment barely enough to pay for the funeral. This is why I strongly feel UIM and UM coverage should be as much as the liability coverage. Anything less and you are putting a higher value on the life of a stranger over family and friends.
There are more types of auto coverage, like medical, to consider. You can dig deeper into the details here if interested.
Good and Bad Homeowners Insurance
Here are a few tips when reviewing your insurance covering real estate owned.
First, the liability issues above still apply here. No state requires you to have homeowners insurance; your mortgage lender will.
Once again I remind you that liability coverage is only one part of the insurance protection. Underinsured and uninsured is still in play.
Most people think homeowners insurance covers you if your house burns down or hail destroys your roof. And that is part of what your policy should cover, depending on the coverage purchased.
Deductibles come into play. Generally, a higher deductible is favorable since it has lower premiums. Homeowners insurance premiums usually have smaller discounts for higher deductibles. Going from a $1,000 deductible to a $10,000 deductible may save so little you may wish to purchase the lower deductible policy anyway. A single claim could cover the entire additional premium cost for many years.
There are several types of homeowners policies available. You can review what each offers here.
Here is why homeowners insurance is necessary in my opinion. A slip and fall on your property can expose you to serious liability risk. There are a thousand ways something can happen on your property that makes you liable. You might have plenty of money to rebuild your home, but an extended lawsuit can leave you exhausted and broke. Just having the insurance company take care of the legal costs and hiring attorneys to defend you can be worth the price of the policy.
Once again, your homeowners insurance agent is someone you need to talk with. The default for most people is an HO-3 policy. You might need to consider riders. Review the difference between deductibles. Some coverage may not be worth it. Example: additional roof coverage in southern states that experience frequent wind/storm/hurricane damage can be so expensive that you would need a total loss more often than ever 10 years.
Your financial situation will help you determine what risks should be mitigated and which to assume yourself.
Good and Bad Life Insurance
Nothing gets the dander up faster than a discussion of life insurance on a personal finance discussion board. Some hate all life insurance and some think it has value. The truth is somewhere in the middle.
Term Life: Let’s start with term life. It is cheap when you are young and provides a fairly large benefit. The problem is that is gets very expensive when you get older. It is considered temporary insurance for a reason.
Who should have term life insurance? Young families come to mind. If a breadwinner in the family dies there can be serious financial issues for survivors.
Single premium term insurance also plays a role in tax strategies such as in charitable remainder trusts.
Business owners can use a buy-sell agreement to protect all the owners of an entity. Term life insurance is cheap enough to cover all parties involved and if one happens to die the funds are available for the remaining owners to buy out the deceased’s ownership. This avoids having to deal with beneficiaries of a business partner or a complete stranger if the ownership is sold to a third-party.
Who should not have life insurance? It is my opinion that single people without dependent children probably do not need term life insurance. If no one depends on your income stream who is the life insurance protecting? When this is the case it is better to save the premiums paid.
Cash Value: Cash-value life insurance gets most of the complaints in the personal finance discussion groups and for good reason. Fees are high and if you really do the math, cash value is usually a really bad idea for a savings or investment account.
Business owners sometimes use cash value life insurance to protect their business. Key Person and Key Employee policies are powerful tools to protect a firm with indispensable persons, such as an owner or employee with specialized skills.
The baby should not go out with the bath water. Cash value life insurance is an appropriate tool in the right situation.
Annuities: Annuities also get a bad rap in the personal finance discussion groups. Fees are once again high. Annuities protect on downside risk, but cap the upside by a significant amount, depending on the policy purchased.
However, there are instances where annuities are the preferred tool.
A Medicare complaint annuity can shelter monies from the look back rules. Generally, monies can be sheltered if the Medicare compliant annuity is funded prior to entering a nursing home. The rules are complex and we don’t have the space to discuss all the details here so I will allow you to further your research here.
Annuities can also be used in several tax strategies such as NIMCRUTs.
Business owners can also utilize annuities in a tax advantaged manner, as discussed above under term life insurance.
Annuities can be used for asset protection.
(As full disclosure, the author had a life insurance license in Wisconsin for over 20 years. I did not renew my license about 5 years ago since I did not sell much life insurance and did not want to be restricted in what I could say in this blog.)
Now that you are aware of my life insurance credentials, I want to share an instance where I think an annuity is appropriate.
I had a client entering retirement many years ago. His health was good, but his family history wasn’t favorable. He wanted a certain level of income now with a higher income income later when his wife retired. He also wanted to guarantee a certain level of income for his wife should he die young.
The solution for guaranteed income was a series of annuities. We started with an immediate annuity (a low commission product so it at least had reasonable value) that paid out for five years before being exhausted. This provided the monthly income stream for the early years.
The remainder was placed into two additional deferred annuities. The first of these was triggered in five years when the first annuity was exhausted. It was a second to die policy so the income stream covered the client and his wife. An inflation rider was added so income is keeping up with inflation. The final deferred annuity was an emergency fund. If they ever needed a larger amount of cash or wanted a larger income stream they had options.
As you can see, some people have a situation where an annuity is a reasonable choice. My client was set on having an annuity. I spent considerable time with my client explaining how this strategy worked because once done there was no going back. So far it is working according to plan.
Bad Insurance or Just Plain Junk
My head hurts when I think about some of the stupid insurance people buy.
Top of the list is the insurance to cover small purchases. If you buy a $100 item you do not need to pay $20 insurance to protect it. Many credit cards protect the item for free if the item is purchased using that credit card. And if you can’t fix or replace the $100 item without the insurance you can’t afford the product in the first place.
Since there is so much junk insurance out there (think of the extended car warranty
scam phone calls everyone gets). Most of this stuff is completely junk with profits sometimes as high as 98%. Yes, some of these junk policies (assuming they are not a scam or fraud) pay out as little as 2% of premiums in claims.
A good rule of thumb is that small levels of insurance are not worth it.
Another bad insurance is dental. Some dental insurance is good, but much of it is a disguised discount only. In other words, you pay less for a dental cleaning and so forth if you buy the insurance. If you have a large dental expense it may work periodically. However, these policies are designed to only work if you come back to the dentist often! And you still pay most of the bill; the insurance is really only a discount! Dental insurance can work in some instances, but usually is self-serving for the dental practice.
Any insurance that covers something you’re already covered for is bad insurance. Credit and debit cards come to mind. Most credit cards have a long list of benefits. Some replace an item if broken or stolen within a year or two. My credit card covers cell phones that are broke and good thing. A few years back I bought a new phone and an ice patch at the office had me fall square on my phone with all my weight, crushing it. The credit card company covered the whole thing at no cost to me.
Disability insurance is expensive, but can save a family struggling financially. If you don’t have the resources to live through an extended disability this type of coverage can protect your hard-earned nest egg.
Long-term care insurance is good for certain situations. If you are really poor it probably isn’t necessary (what can they take if you don’t have financial resources) unless you want the ability to choose a better long-term care facility. If you have a high net worth you can self insure.
It is those folks in the middle most at risk. A $300,000 net worth, for example, can be severely damaged if you end up in a nursing home. A few years of this and there is no nest egg. If you have a spouse or others counting on your legacy it is best to protect it.
Life insurance is a powerful tool in estate planning. The number of policies available is large. You need to work with a qualified tax and accounting professional along with a qualified estate planning attorney when estate planning. The issues are many and complex.
The cheapest and best insurance usually protects against rare occurrences, but when they happen are high ticket items, taking you out financially. The goal is to avoid the train wreck. A broken laptop should not be a major catastrophe requiring insurance coverage. A $100 toy certainly does not require insurance! But a $1 million lawsuit is a life changing event. You might want to protect against that.
When it comes to insurance common sense goes a long way. Junk insurance like the stuff you get offered at Amazon or Best Buy when purchasing a cat pillow is insane. And the premiums are frequently 20% or more of the product price. Are these things built to fail before the manufacturer’s warranty expires?
Intelligent insurance purchases take a small amount of math as you saw at the open of this blog post. I help clients in my practice on a regular basis decide what insurance and deductible level that is most appropriate for them. One size does not fit all. It always comes down to some simple math.
Shock insurance, the stuff that gets offered to you at the spur of the moment where intelligent people would not even expect to be pitched, is the worst. I avoid insurance offers that come to me.
Always shop around. Get a few quotes from highly rated insurance companies. Get the best policy for your needs and no more. If you don’t want to overspend on insurance, avoid insurance you don’t need.
As always, use common sense. Talk to the insurance agent when shopping for auto, life, long-term care, disability and homeowners insurance. They get paid to help you make a proper choice. If you don’t ask they will sell whatever you ask for and cash their commission check. Good agents want to talk with their clients. Don’t push them away. It is their job to help you.
And always do some independent research. This blog post is a good start. Check prices and what policies cover. Doing research when you need to make a claim is not research; it is reacting. That is the wrong way to do it.
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