Risk Pooling

SOME RISKS LOOM SO large that the only prudent option is to pool risk. That’s what we do when we buy insurance. We toss our premium dollars into a pool of money overseen by an insurance company.

If we’re unlucky—our house burns down or we suffer a disability—we collect from the pool. If we’re lucky, we pay our premiums and get nothing in return. Most of the time, that’s what we want, because it means another year has passed without major misfortune. The one exception: With lifetime income annuities, which are a form of insurance, you hope to get heaps of money back because that means you’re enjoying a long life.

While insurance is a great way to manage risk, it’s also expensive, so you only want to buy coverage if it’s absolutely necessary. When is that? Think about the financial misfortunes that could befall you.

Could you cope financially if you crashed the car, your spouse died, you couldn’t work because of an accident or illness, your neighbor sued you or you needed to pay nursing home costs? If the answer is “no,” you likely need to buy insurance. If the answer is “yes” or “maybe,” you might skip the insurance or buy a policy with relatively skimpy coverage. Often the decision will hinge on your net worth. Suppose that, even if illness prevented you from ever working again, you’d still be okay financially. In that case, you might not bother with disability insurance.

Next: Enough

Previous: Skewness

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