Rethinking Insurance: What You Really Need; What You Don’t

Call it bass-ackwards insurance: people tend to insure things they could easily afford to replace and fail to insure against financial catastrophe.

There are a lot of reasons we get this wrong. We’re optimists: we know bad things happen, but assume the worst won’t happen to us. Sure, someone might my steal my iPhone, but becoming permanently disabled? Not me.

And we hate to sit down with an insurance agent and maybe get talked into something we don’t need.

Insurance is very different from any other financial instrument, because we buy it hoping we’ll never need it. I don’t want to die young. My insurance company doesn’t want me to die young, either, because they’d lose money. It’s hard to make yourself spend money on something you don’t want.

Stephen Madeyski, a certified financial planner in Albuquerque, offers a simple rule when considering insurance. “Insure what you cannot afford to lose,” he says. In other words, insure against big, unlikely disasters–not small annoyances.

To this, I’d add my own aphorism: Insurance exists to prevent personal disasters from becoming financial disasters.

Let’s see what happens when we apply these rules to the most common types of insurance. I’ll be talking about health insurance in a separate column.

Life insurance

People make two common mistakes with life insurance: buying too little and buying the wrong kind.

Life insurance is there to protect the people who depend on your income. If you don’t have anyone who depends on your income, you don’t need life insurance.

If you do have dependents, though, you probably need more life insurance than you think. Madeyski recommends multiplying your salary by 25. “In other words,” he says, “if you need to replace an income of $100,000, then you multiply by 25, which means $2.5 million.” That’s more insurance than many planners recommend, but it’s not as crazy as it sounds: people expect a lump sum to go farther than it actually does.

Here’s a life insurance calculator from SmartMoney that can tell you whether you’re in the ballpark.

The right kind of life insurance is term life: it insures against your death during a specific period of time, and for people in good health and 65 or under, it’s quite inexpensive. Insurance agents also peddle all kinds of complicated cash-value life insurance products. “ ‘You’re insuring and you’re also saving for retirement’—that’s a red flag for me,” says Madeyski. Other phrases to avoid: “no downside,” “equity-linked,” “variable annuity.”

Smile. This is one of the few times in life you’ll encounter a genuinely black-and-white good-and-evil decision. Term life good, anything else bad.

Disability insurance

This is the black hole of insurance. Madeyski finds that his clients “tend to underinsure on the big things. And in my mind, the biggest is DI, disability insurance.”

Financially speaking, disability is a fate worse than death: your income is wiped out or reduced, but you’re still around, spending money. It’s also much more common than death. “Statistics show that we are 3 to 10 times more likely to be disabled during our working life than to actually die,” says Madeyski.

Furthermore, disability insurance is expensive. Get it through your job if you can, and through an affinity group (such as a professional organization or college alumni association) if you can’t. Individual DI is the most expensive and therefore the last resort, but it’s better than going without.

Homeowners or renters insurance

The gold standard in homeowners insurance is full replacement coverage, which covers the cost of rebuilding your home if it’s destroyed. “People should get replacement coverage,” says Madeyski, “because building costs haven’t really gone down, even though real estate values have.”

Renters insurance is cheap. To keep it that way, choose a high deductible and consider carefully whether to make a claim. The event you’re insuring against is a major burglary, fire, or other natural disaster—not a broken window from playing indoor hockey.

Extended warranties

You already know what I’m going to say about these—everyone knows that financial columnists think they’re a ripoff, but not everyone understands why. Let me explain.

On the face of it, an extended warranty seems like a good deal. You buy a new laptop. For $120 extra, it’s covered for three years. During year two, the screen blanks out during a game of FarmVille. You ship the laptop back to the manufacturer and it comes back to you good as new; you didn’t lose so much as a goat. Since the price of a new screen, labor, and shipping is more than $120, it feels like you won.

And you did: you won a particular bet. Now let’s put extended warranties on your cell phone, stereo, Blu-Ray player, and TV. And buy a new warranty every time you replace one of those items.

Now it’s not such a good deal anymore. The reason Best Buy sells those warranties is because they know that, on average, Best Buy wins the bet. But that’s also true of life insurance, and I just told you to buy life insurance.

There are two differences here, though: First, there’s only one of you, but you own a bunch of different electronics over a long period of time, so you get to diversify away the risk that any one piece of equipment will fail. Second, the loss is so minimal—the most you’re out is the price of a computer or TV—that you can afford to insure it yourself.

I don’t mean this just as a thought experiment. You could actually do this. If you’re thinking about buying an extended warranty, put the money into a savings account instead. You’ve just become your own insurance company. Over time, you’ll spend less on fixing or replacing your own stuff than you would have on warranties, and you’ll never have to argue about whether a particular mishap is covered.

Travel insurance

The New York Times travel section recently published a piece called When in Doubt, Insure. The article, however, said mostly the opposite.

“Costs can vary from about 3 to 16 percent or more of the total trip price, depending on the traveler’s age, and the cost and length of the trip,” said the Times. But that understates the cost, because most travel policies have all sorts of exceptions, and policies that truly cover everything (which is called a “cancel for any reason” add-on) are the most expensive and only cover 75% of your trip expenses.

Furthermore, collecting on travel insurance can be as much of an adventure as any vacation. That’s why it’s a staple of consumer advocate columnists, such as the Times’s own Haggler.

Buying travel insurance regularly only makes sense if you assume that, over your lifetime, 16% of your vacations will be unexpectedly canceled. Your life doesn’t suck that much, does it?

Travel insurance is basically the same as an extended warranty: expensive insurance on something you could afford to insure yourself.

There are two exceptions, however. First, if your medical insurance doesn’t cover you abroad, buy supplemental travel coverage. Second, if you usually take inexpensive vacations but have spent a decade saving up for a once-in-lifetime trip, that’s a big downside risk. Go ahead and insure it.

So, to put Madeyski’s law yet another way: When you can afford to be your own insurance company, do it.

Matthew Amster-Burton, author of the book Hungry Monkey, writes on food and finance from his home in Seattle.