Getting Comfortable With Insurance Planning

Insurance isn’t always the most popular topic. In fact, surveys have found many individuals neglect regularly reviewing insurance needs as the conversations can be very uncomfortable (especially when it comes to life insurance). While insurance is something that’s often overlooked, it can play an important part in regard to your complete financial plan.

The primary objective of insurance is to provide protection against risks, specifically “pure risks”. With pure risk, there is a chance of either loss or no loss, and the outcome cannot always be controlled (e.g. death, auto accident, or a house fire). Additional risks include speculative, subjective, and objective risks. While we won’t dive into all of the various forms of risk, there are several methods for managing risk:

• Risk Avoidance entails avoiding risk altogether by refusing to engage in actions that create the risk. For example, refusing to drive a car so there’s no chance of an accident. This is the most extreme form of risk control, but it may not be practical in all instances.

• Risk Reduction decreases risk by taking specific safety measures. For example, driving a car, but making sure to follow the speed limit and use turn signals to reduce the risk of an accident. This method aims to reduce the frequency and severity of losses while still participating in events that contain risk.

• Risk Retention is when you take no action to avoid, reduce, or transfer risk. This is a form of self-insurance and is the riskiest option available. Self-insurance can be appropriate if you can afford to pay out of pocket for a specific financial loss. However, this is not advisable if an unexpected loss would have a catastrophic impact on your financial situation, such as driving without car insurance and getting in a major accident. 

• Risk Transfer shifts risk to others, usually through the form of an insurance contract. As a result, you will pay a premium in exchange for future compensation if a specified loss / risk event occurs. Insurers can afford to accept your risk, along with the risk of many other people, by using probability analysis with the law of large numbers (the larger the number of people involved, the more likely we are to experience the expected loss probability). Examples of this would include purchasing auto and homeowners insurance policies.

The overall objective of risk management is to choose the most efficient combination of the above methods in order to avoid a catastrophic loss. While risk avoidance, reduction, retention, and transfer are relatively self-explanatory, understanding insurance products can still be confusing and overwhelming. 

For example, if you want to transfer the risk of a premature death, which may leave your family in great financial stress, there’s the option to purchase a life insurance policy – but how do you know which type of policy fits your needs the best? Or in the event that someone believes they may incur nursing home expenses later in life and are looking to purchase long-term care insurance – what features are right for their situation? 

Questions like these are why it’s important to work with a CFP professional to ensure you’re implementing the best-fit insurance products for your unique situation.

While insurance planning can seem like a daunting task, understanding the basic methods of risk management and getting comfortable with the conversation is a good step in the right direction.

Ben Webster, CFP® and Derek Prusa, CFA, CFP®

Co-Founders and Owners of Aspire Wealth