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Understanding Insurance: The Fundamentals of Risk

Geico Gecko

Some people call it a necessary evil, some call lit a racket and others call it institutionalized gambling. Whatever you call it, insurance is a fact of life, and one that you need to understand in order to succeed financially.

If you’re an adult, you’ve likely dealt with some form of insurance already. You can’t legally operate a vehicle without auto insurance. If you own a home, your mortgage company requires you to carry homeowner’s insurance. There’s been an ongoing national dialogue about health insurance for years now. And if you have a family, there’s a good chance that you’ve thought about the need for life insurance as well.

The insurance world can be intimidating — it’s filled with all sorts of jargon, legalese, arcane rules and small print. Insurance can also be painfully expensive, and the difficulties that sometimes arrive when you try to collect on a claim can cause no small amount of frustration. Given all these factors, many people get the wrong idea about insurance, and some people make the dangerous choice to forego it altogether.  That’s too bad, because understanding insurance and using it well can be an essential element in your financial success. In these series, Understanding Insurance, we’re going to look at many of the things that you need to know to make insurance work for you. To start, though, we need to get a fundamental understanding of risk.

In our affluent Western society, it’s easy to fall into a false sense of security. We live in so much relative peace and comfort that we can develop the attitude that nothing bad can happen to us. But true safety is a myth: The world that we live in is a dangerous place, and there’s nothing that we can do to ever totally remove danger from our lives. Although our world can look safe and risk-free on the outside, all it takes is one car crash, one house fire or one sports injury to pull back the veil on this life and reveal the dangers that lurk around every corner.

I’m not writing this to scare you (after all, God hasn’t given us a spirit of fear). But I want you to understand that there are inherent risks all around us in this world, and many of the dangers of life are things that fall entirely out of our control. You could be walking along one day, minding your own business, and be injured by any number of people or things that you didn’t see coming. That’s not your fault, but it can make a profound impact on you life.

When you think about it, of course, we’re all  subconsciously aware that there are risks in the world, and we take steps to mitigate those risks. You know that cars are dangerous, so you don’t walk in the middle of the street — you use the sidewalk to avoid the risk of getting hit. That doesn’t mean that you can’t get hurt on the sidewalk, but the risk of getting hit by a car on the sidewalk is far less than the risk of getting hit in the street.

One of the great troubles about the risks in our lives is that they bring a lot of financial complications. Fixing a car, rebuilding a home, or treating someone who is ill can cost serious money — easily tens or hundreds of thousands of dollars. This means that the fundamental risks in our universe threaten not only your physical life, but also your financial life as well. Indeed, one unforeseen disaster can spell doom for your entire financial world if you’re not careful.

We can never completely remove the threat of physical injury from the riskiness of our world. Fortunately, we can remove the risk of financial catastrophe, and we do that through insurance.

Many people misunderstand insurance. They think that they buy insurance policies so that the insurance company will pay for their needs one day if some kind of accident or illness occurs. And though that’s an element of insurance, this narrow point of view can lead to some real misunderstanding of insurance. If you pay into a policy for years without ever making a claim, you can start to feel like you’re wasting your money. After all, you keep giving the insurance company money every month, but they never give you any back. What is the point of that, and how is it a good deal? Many people, in fact, believe that insurance is a rip-off, one that they’re forced to participate in against their will. Some people are so ignorant about insurance that they refuse it altogether.

The problem with that thinking is that it fails to properly value risk. You see, when you buy insurance, you’re not just obtaining a golden ticket that will cover you in the case of catastrophe — you’re actually asking the insurance company to assume the risk that exists in your life. When the insurance company issues you a policy, they’re effectively taking the financial risk out of your life and putting it on their shoulders. In exchange, they’re charging you a monthly fee to do that. That means that the risk in your life has a value.

You’re willing to pay the car insurance company $50 each month, for example, to insure you in case of a wreck. What that really means is that it’s worth $50 to you each month to escape the financial risk that comes with driving. The same is true with homeowners insurance, life insurance, etc.

When you buy insurance, what you’re buying is protection from risk. From a financial point of view, it doesn’t matter if you ever have to make a claim against the policy. It doesn’t matter if the insurance company ever has to pay you a dime. Because you’re not really buying an insurance payout — you’re buying protection from risk. For every month that the insurance company protects you from risk, there’s value, whether or not disaster occurs. In other words, you don’t just get your money’s worth out of insurance when a disaster happens. The value of insurance comes every month that you don’t have to live with risk in your financial life.

It sounds cliche, but when you buy insurance, you’re really buying peace of mind. The payout is secondary. Insurance is valuable because it removes risk from your life. You’ll get your money’s worth out of good insurance policies every month, whether you ever have to file a claim or not. And that’s what makes insurance different than gambling.

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Photo by kelsey_lovefusionphoto. Used under Creative Commons License.

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Trackbacks

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Copyright Brian Jewell, 2011-2013

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All content on this site is given on a general basis and is intended for informational use only. The content does not reflect any professional legal, investing, accounting or tax advice, and should not be used as the sole basis for making financial decisions. Always consult a certified financial professional before investing.
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