FXCoral

When to buy and not to buy insurance...

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A while back...

I had a conversation with my friend about flood insurance. He told me that having flood insurance wasn't necessary for him because the risk was very low that his house would be damaged by a flood.

My friend lives about a mile away, and my wife and I have flood insurance. We are all in the same flood plain. And in the past 10 years, we’ve had 3 storms that have caused widespread flooding in our area. Hurricane Laura just missed us yesterday.

I am not certain if he has any other motivations, but avoiding an annoying $50 monthly premium is the reason my wife and I didn't have flood insurance before 2015. And really, who wants another bill? But this conversation made me think about something; when to buy and not to buy insurance.

Buying insurance for the big stuff.

Insurance is pretty simple, you pay the insurance company or government a premium, say $50/month, and they will pay for most of the damages to your property caused by some bad event, so you don't have to pay.

Insurance is specifically tailored to protect you from significant financial loss, which is a loss that takes years or decades to recover from financially. Its usually not advantageous to get it for the small stuff.

For example, if you buy a computer hard drive for $50 and the hard drive fails, you are out $50. If your monthly budget surplus is $200, it will take you one week to recover from this loss, so you probably don't need insurance.

However, if your house is flooded, and you are out $50,000, it will take you 20.8 years to recover. So you probably need insurance. There are a few caveats to this, but you get the idea.

To evaluate whether or not you need insurance protection against significant financial loss (in the 2nd example), it’s good to understand three concepts; risk, exposure and recovery.

Risk, Exposure and Recovery.

  1. Risk is the probability of something bad happening.
  2. Exposure is how much money you will lose when that bad thing does happen.
  3. Recovery is how long it will take you to get to the same financial position you were before the bad thing happened.

These 3 terms are used in finance to gauge the financial soundness of a particular action or inaction. It can also be applied to the individual. For example:

  1. I accept the 10% risk of a hurricane causing damage to my home in any given year.
  2. I accept the 100% financial exposure (loss of money) when the hurricane damages my home.
  3. I accept that it will take 10 years to recover to the same financial position that I was before the hurricane damaged my home.

To buy insurance, or not to buy insurance.

In all cases, everyone accepts the ‘risk.’ But you have the option of passing the ‘exposure’ to someone else (an insurance company or government) and recovering faster from the financial loss.

If the above 3 points are 'not' acceptable to you; you buy insurance and pass that exposure to the insurance company or government. If the 3 points are acceptable to you; you don't buy insurance and accept the financial exposure.

I don't know about anybody else, but taking an entire decade to financially claw my way back to the same position that I was 10 years before would annoy the shit out of me, not to mention the emotional trauma. But that’s just me, haha.

Stay frosty people. Thanks for reading.

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