This is another installment in our Financial Independence Series- a series of articles complete with advice and strategies that most anyone can implement right now to help move closer to financial independence. Be sure to read the other entries in this series and start saving today!
Life carries with it a host of expenditures. We receive our paychecks, we pay our mortgages, car payments, credit cards, etc. We purchase food, supplies, and other things and hopefully have enough left over for investment and entertainment. Somewhere in the mix, there is an allocation for insurance and with the rising costs of insurance premiums and the expansion of the insurance industry, finding the right level of insurance for you and your family is an important component in the battle for financial independence.
Insurance and its Uses/Limitations
Insurance is a contract. It’s an agreement to settle the costs of an unforeseen event, minus a specified amount (deductible) that you, the insured, are expected to cover yourself. Insurance is the pooling of money from hundreds, thousands, or even millions of people to cover the expenses of those who need help when the unexpected happens.
Insurance is very important in the case of a catastrophic event. No one wants to watch their home burn to the ground or discover they need major surgery and realize they don’t have any insurance. With basic levels of insurance for your residence, health, car, etc., you can rest much easier and know that, if something goes wrong, insurance will be there for you. But insurance (with the exception of certain life insurance plans) was never intended as an investment. You can’t expect insurance to pay more than you need to cover losses. Insurance is meant to make you whole- to get you back to where you were before the unforeseen event took place and nothing more.
The key to winning the insurance game is the selected deductible. The amount of insurance also matters, which I will discuss in a minute, but let’s focus on the deductible first. It’s one of the insurance components most of us have at our disposal but few use correctly.
With deductibles, the best bet, from a cost savings and financial independence strategy, is to select a higher deductible. Low deductibles mean you won’t have to pay as much out of pocket when you wreck your car, enter the hospital for a major operation, etc. But they also mean paying much higher premiums today and, unless you’re accident prone, you will pay much more in the long run if you go with a low deductible.
Let’s take a look at a simple example involving car insurance and three possible deductible options:
Deductible Amount Monthly Premium Cost
Which of these options is best? People can make arguments for each, but the best bet for those who want to conserve cash is the $1,000 deductible. The reason is because the additional premium cost associated with a low deductible simply isn’t worth it in the long run. You will end up paying much more out of pocket expense, and this is particularly true with the $250 deductible. Comparing the two extremes, the person with the $250 deductible will pay $80 more per month (170 – 90 = 80) than the person with the $1,000 deductible. The deductible difference is $750 ($1,000 – 250 = 750). Thus, if I feel confident that I can go the next 9 months or longer without causing an accident (750 divided by 80 = 9.38 months to recoup the difference), I will save money with the higher, $1,000 deductible.
Some have tried to make the argument that the lower deductible is better because it makes them feel “safer” and is best for those who have multiple accidents each year. I’ve got news for you: If you have multiple accidents per year, you actually will not save any money in the long run because your insurance company will increase your premiums or, depending on the severity of the losses, drop you from its coverage plan completely. You will then be forced to find car insurance for high- risk individuals and will pay a much higher price in the end.
Going to Extremes
Like with everything in life, there are some people who take insurance to extremes. They insure everything under the sun, go with the lowest possible deductibles, and otherwise break every rule of sound personal financial management. They will select insurance plans for their car, home, and health that are completely unreasonable and provide coverage levels that are unrealistic and will likely never be used. They will sometimes even pay for insurance through multiple providers for the same coverage, such as paying for health insurance through both spouses’ employers (yes, you read that correctly!) because it makes them feel “safe.”
Purchasing excess insurance might gain some additional peace of mind, but the overall out of pocket cost in the long run will far exceed the value of the benefits received. The irrational behavior that some people display with excess insurance is baffling. They will pay, for example, an additional $200 per month in health care coverage so that they won’t have to pay $100 out of pocket each month for a doctor’s office visit that they make only a three times per year! It makes no rational sense at all, but there are people who conduct their financial lives in exactly this manner.
With insurance, consumers need to keep in mind that insurance in any form (with the exception of certain types of life insurance) is an expense, plain and simple. Not only that, but it’s an expense that carries with it no tangible reward. Unlike entertainment, travel, and even necessities like food and gasoline, insurance is…..nothing. You are paying for an agreement and that’s it. Once the time has expired, your money is long gone, never to be seen again and you have nothing tangible to show for it.
Necessary but Controllable Evil
Insurance is a necessary evil. It is important to have some insurance and we at Money Saving Parent would never advocate the elimination of insurance from a household budget. Everyone should have some insurance to cover unforeseen personal disasters. Without insurance, a family could lose tens of thousands of dollars and could even be forced into bankruptcy.
As important as insurance is, that doesn’t mean that over- insuring is a virtue. Purchasing excess coverage, selecting low deductibles, and making otherwise irrational decisions with insurance coverage because it “makes me feel good” can be detrimental to household cash flow. It can drain a family of funds that could be used for something worthwhile; something that has tangible and/or investment value that can build net worth. Insurance premiums are a payment for an agreement for a specified period of time. You don’t gain anything of direct value when you buy insurance, so it makes sense to keep this aspect of your financial life under control.
Everyone should buy insurance to protect the important things in life, but be smart about it. The main reason to purchase insurance is to cover catastrophic losses, not to pay for a $100 doctor’s office visit. A higher deductible can lower premium costs considerably and result in more money in your pocket each month. Don’t let your money go up in smoke- keep these things in mind the next time you’re presented with insurance options and you will be well on your way to financial independence.
Other entries in this series:
Copyright 2014, Bryan Carey