Being properly insured is one of the most important steps anyone can take toward financial security. Yet it is also one of the most confusing areas of personal finance. The combination of high stakes and high complexity often leads people to make poor decisions about how best to protect themselves and the ones they love.
Today, I want to share a few simple guidelines to help you distinguish between the types of insurance that are truly essential and those that may not be worth the cost.
Guideline 1: Measure the Financial Impact of a Loss
Before buying a policy, ask yourself: Could I afford this loss without insurance? For example, you may see ads for “car repair” insurance on television. If you have a solid emergency fund with several months of expenses set aside, an unexpected car repair probably will not derail you financially. On the other hand, imagine your home catching fire. Rebuilding or replacing it would cost far more than most people could handle out of pocket. That is a loss worth insuring against.
Remember, that the purpose of insurance is to transfer risk from yourself to someone else. The more severe and unpredictable a potential loss is, the more vital it becomes to insure against it. That is why homeowners, health, and long-term disability insurance are essential for most households, while coverage for your phone, pet, or personal identity generally falls into the optional category.
Guideline 2: Think About Who the Insurance Protects
Life and disability insurance are two of the most important types of protection for working adults because others often depend on their income or household responsibilities. If your absence would cause a major financial hardship for your loved ones, you need to make sure they are protected.
That does not mean everyone in the household needs the same level of coverage. Children, for instance, rarely require more than a small life insurance policy to cover funeral expenses. A good general rule of thumb is to have life insurance coverage equal to about ten times your annual income and between 60%-70% of your pretax income in long-term disability insurance.
Guideline 3: Know What Is Legally Required
Some insurance is not optional because it is required by law. Auto liability and workers’ compensation are two common examples. Even if you could afford to self-insure these risks, failure to carry them can result in heavy fines, license suspension, or even jail time. The financial and legal consequences of not being covered are simply not worth it.
No one enjoys paying for something they hope never to use, but wisdom often requires discipline over comfort. The key is simple: if a loss could destroy your financial life, insure it. If it would only inconvenience you, skip it. By understanding the risks, you can focus your dollars where they make the biggest difference, protecting what you cannot afford to lose.
(Past performance is no guarantee of future results. The advice is general in nature and not intended for specific situations)