Cover Me

Jonathan Clements

IF YOU ASK AN insurance agent how much coverage you should have, the answer invariably is “more.” What if you show too much interest? Next thing you know, you could find yourself the unhappy owner of a high-cost variable annuity.

Consumers, meanwhile, take what might be politely described as a barbell approach. Sometimes, they’re acutely aware of a particular risk and buy more coverage than they need—a frequent occurrence with auto and health insurance. But in other instances, they simply ignore the risk. This leads folks to skip life, umbrella liability, disability and long-term-care insurance.

Want to make more rational decisions? Keep in mind these 11 rules of insurance:

1. When we buy insurance, we’re pooling risk. If we have a claim, the check may come from the insurance company. But in reality, the money’s coming from other insurance buyers. We toss our premium dollars into a risk pool, from which claimants are then paid.

2. We should hope never to collect. If we don’t ever have a claim—and hence we’re paying premiums and not getting anything back—that’s a sign that life is good. No car crashes. No house fires. No untimely deaths.

3. There’s a key exception to rule No. 2: If we buy an immediate-fixed annuity that pays lifetime income, we want to get money back—and lots of it—because that means we’re enjoying a long life.

An aside: While most annuities are horrible products, I’m a fan of immediate-fixed annuities that pay lifetime income. It’s the same reason I favor delaying Social Security to get a larger monthly check. Both strategies allow you to hedge longevity risk—the danger that you’ll outlive your savings.

What if you’re going to use just one strategy? I’d delay Social Security. Why? Immediate-fixed annuities suffer from so-called adverse selection. While Social Security serves the broad population, insurers know healthier folks tend to buy lifetime income annuities, so they price them accordingly—and the payoff isn’t as attractive as the payoff from delaying Social Security.

4. We should fret less about getting the right-size policy—and focus more on purchasing at least some coverage. It can be hard to know precisely how big a policy to get, especially with umbrella liability and life insurance. But don’t let that deter you from getting at least some coverage, assuming you need it.

Why? If you get slapped with a lawsuit, carrying some umbrella coverage should ensure the insurance company gets involved, fighting on your behalf. If you go under the next bus, owning some life insurance will give your family at least a modicum of financial breathing room, as they recover from the tragedy.

5. Our chances of dying are 100%—so the insurance component of permanent life insurance, which is intended to be held until death, will invariably be costlier than that of term insurance, which provides coverage for maybe 20 or 30 years.

Permanent “cash value” life insurance also involves high costs, plus you’re required to pay into an investment account, which is how you build up that cash value. In fact, the premiums on permanent insurance are so high that many people let their policies lapse. That means these folks fattened the wallets of the insurance companies and their agents, while getting scant benefit themselves.

6. Never buy investments from an insurance company. This includes not just cash-value life insurance, but also variable annuities and equity-indexed annuities. Agents hawk this garbage because it pays them fat commissions. What about sensible, low-cost investments, like index mutual funds and exchanged-traded index funds? Even if insurance agents are licensed to sell these sorts of securities, they probably won’t recommend them, because there’s little or no commission to be earned.

7. Insurance companies usually pay out less in claims than they receive in premiums, so insurance buyers collectively lose money. That doesn’t mean insurance is a bum deal—provided that, in return for our premium dollars, we’re getting protection against major financial risks.

But what if we’re talking about minor financial risks, such as the windscreen cracking on our car or the new television going kaput? Because insurance will usually be a money loser, we don’t want to pay premiums to protect against risks we could easily cover out of pocket. Result: We should usually skip extended warranties—which are a type of insurance—while also opting for insurance policies with higher deductibles and longer elimination periods. The latter kicks in with disability and long-term-care insurance. It’s the time between when we make a claim and when benefits begin.

8. Two exceptions to rule No. 7: extended warranties on electronics bought for children and trip-cancellation insurance if you’re elderly. Both extended warranties and trip-cancellation insurance are classic examples of bad insurance: We’re charged relatively large premiums to protect against relatively modest financial risks. But given the frequency with which kids destroy iPads—and senior citizens need to cancel trips for medical reasons—these policies may make sense in these two special cases.

9. It’s important to favor insurers with a top rating for financial strength. That’s especially true if you’re dealing with a life-insurance company—those that insure humans—rather than property-casualty insurers, which write coverage for houses, cars and other property.

Indeed, while you might shop for the lowest premium for auto and homeowner’s insurance, that isn’t necessarily a good strategy for policies you plan to hold for the long haul, like life and long-term-care insurance. Why not? A very low premium may mean that the insurer has misjudged the risk involved and you could face large premium increases down the road—something that’s happened frequently with long-term-care insurance.

Even more worrisome: The low premium could indicate the insurer is in shaky financial shape, and it’s struggling to attract new business or it’s hoping to compensate for low premiums by aggressively investing premium dollars. Either way, there’s a risk the insurance company won’t be there when you need it.

10. Carrying insurance creates a so-called moral hazard—meaning it changes our behavior. Those with health insurance are more inclined to see the doctor and may be more inclined to take physical risks. Those with long-term-care insurance are more likely to go into a nursing home—one of the problems insurance companies failed to anticipate and which is why many are now requesting obscene premium increases. Feel like insurance is overpriced? You can blame that, in part, on moral hazard.

11. Our insurance needs change over time, so we should review our coverage every few years. If we get married or have children, we might need more life insurance. But as our savings grow, we can take the risk of higher deductibles and longer elimination periods—and we may be able to drop some insurance policies entirely.

Indeed, if we have enough set aside that our family would be okay financially if we died tomorrow, we might let our life insurance lapse. Similarly, if we have a big enough nest egg to pay nursing home costs out of pocket, we might skip long-term-care insurance.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Singled OutOn the Other Hand and Five Crashes. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.

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