Insurance is one of the most powerful tools in a financial plan. The trick is knowing when to use it.
There is a common perception that fee-only financial planners don’t like insurance. I understand where that perception comes from. Some insurance products are sold as investments. Some combine insurance and investing in complicated ways. And some products can generate substantial commissions for the person selling them. As a fee-only financial planner, I don’t receive commissions for recommending insurance. But that doesn’t mean I don’t like insurance.
Quite the opposite.
Insurance can be one of the most valuable tools in a financial plan because it allows you to transfer a potentially devastating financial risk to an insurance company in exchange for a relatively predictable cost. The key isn’t deciding whether you should have insurance.
The key is deciding which risks are worth insuring and which aren’t.
Think About Risk Before You Think About Insurance
A useful way to think about insurance is to first categorize the risks in your financial life based on two questions:
- How likely is the event to occur?
- How financially damaging would it be if it did?
That gives us four basic categories.
1. Low Probability + Low Cost: Self-Insure
If something is unlikely to happen and the financial impact would be relatively small, you probably don’t need insurance. You can simply absorb the cost yourself.
For example, if your car insurance deductible is $1,000, you don’t need to create a separate insurance policy to protect yourself from the possibility of paying that $1,000. You simply keep enough cash available to handle it. This is essentially self-insurance.
The same concept applies to many smaller risks. Insurance exists to protect against financial consequences that would be difficult or impossible for you to absorb, not necessarily every expense that could possibly occur.
2. Low Probability + Large Cost: This Is Where Insurance Shines
This is the sweet spot for insurance. You may never experience the event, but if it happens, the financial consequences could be enormous.
Your house burns down.
You are involved in a serious liability lawsuit.
A major disability prevents you from working.
A premature death eliminates a family’s primary source of income.
You need extensive medical care.
These events may be relatively unlikely for any one individual.
But the financial consequences can be enormous.
This is exactly the type of risk insurance was designed to transfer. You pay a known, relatively manageable premium to protect yourself against a potentially catastrophic financial loss. That is a pretty powerful financial planning tool.
3. High Probability + Large Cost: Avoid or Reduce the Risk
This category is particularly important because insurance isn’t always the best answer. If something is both highly likely to happen and financially damaging, the first question shouldn’t necessarily be: “What insurance can I buy?”
It should be: “Can I reduce or eliminate the risk?”
Sometimes the best insurance policy is changing the underlying behavior. If a particular activity creates an unusually high probability of a significant loss, avoiding the activity may be more effective than simply purchasing additional insurance. Risk management starts with risk avoidance and risk reduction before risk transfer.
Insurance is one tool in the toolbox, not the entire toolbox.
4. High Probability + Small Cost: This One Requires Judgment
This is where insurance decisions can become more nuanced. If something happens frequently but the financial impact is relatively small, insurance may not be particularly valuable. Why? Because insurance isn’t free. The insurance company has to price the policy to cover expected claims, administrative expenses, reserves, profit, and other costs.
So if you can comfortably absorb the loss yourself, paying someone else to take that risk may not make economic sense. But there are exceptions. Sometimes the cumulative cost of repeated smaller losses can become meaningful. Sometimes the risk is difficult to predict. Sometimes insurance provides valuable protection beyond the immediate dollar amount of the claim.
The point isn’t that you should always self-insure these risks. The point is that the decision should be intentional.
Insurance Is About Risk Transfer: Not Necessarily Wealth Creation
This is where I sometimes part ways with the way insurance is presented as a financial product. There are insurance products that combine an insurance component with an investment or cash-value component. They can be useful in the right circumstances. But combining two things doesn’t automatically make the combination better. In fact, I like to think of some of these products as the financial planning spork. A spork is technically both a spoon and a fork. But if I’m eating soup, I’ll take a spoon. If I’m eating a steak, I’ll take a fork.
The fact that the spork can perform both functions doesn’t necessarily make it the best tool for either job. Financial products can work the same way. When the primary objective is investment growth, there are often investment tools specifically designed for that purpose. When the primary objective is transferring a financial risk, there are insurance products specifically designed for that purpose. Sometimes there is a legitimate reason to combine the two. But sometimes the combination exists because it makes the product easier to sell, not because it produces the best outcome for the client.
Think of Your Financial Plan as a Toolbox
I think about financial planning much like an experienced craftsman thinks about a toolbox. A good craftsman doesn’t insist on using the same tool for every job. They use the right tool for the job. A financial plan should work the same way.
- Insurance is a tool for managing risk.
- Investments are tools for building and managing wealth.
- Cash is a tool for liquidity and short-term needs.
- Fixed Income can provide stability and income.
- Stocks provide long-term growth potential.
- Estate planning tools address different transfer and legacy objectives.
- Tax planning strategies address tax exposure.
The goal isn’t to find one magical financial product that does everything. The goal is to assemble the right collection of tools to accomplish the client’s specific objectives.
So, Do I Recommend Insurance?
Absolutely! I recommend insurance when it solves a problem that insurance is well suited to solve. I don’t recommend insurance simply because insurance exists.
A good financial plan asks:
- What could go seriously wrong?
- How likely is it?
- What would it cost?
- Can we avoid or reduce the risk?
- Can we comfortably absorb the loss ourselves?
- If not, what is the most efficient way to transfer that risk?
Sometimes the answer is insurance. Sometimes the answer is self-insurance. Sometimes the answer is changing the underlying behavior and sometimes the answer is some combination of all three. That’s the beauty of financial planning. There isn’t a single product that works for everyone. There is simply the right tool or combination of tools for the job. So, as a fee-only financial planner, I don’t hate insurance.
I just don’t want you eating your financial plan with a spork.