Insurance and Risk Sharing
An unexpected event such as a death, disability, or other personal loss, is certainly not something for which you can easily plan. Yet, the financial ramifications can be staggering—not only to you, but to your family, as well. Therefore, it is important to create a risk management plan as part of your overall financial strategy.
Insurance, in all its varied forms, is simply a method for managing risk. In order to plan an effective insurance program, consider what risks you and your family are exposed to and how financial loss would affect you. For each risk exposure, the key elements to consider are the severity and possibility of loss.
All Risks Are Not Created Equal
Some risks may be so small that you decide to accept full responsibility for any potential loss. In insurance language, you “self-insure” for such risks. For example, it is rarely cost-effective to carry collision coverage on a 10-year-old automobile. Collision coverage generally pays actual cash value, and since a 10-year-old car may have little current fair market value (FMV), it is common to self-insure in such cases. In making this choice, you assume full responsibility for any accidental damage you may cause to the vehicle.
In other situations, the risk may be so large (or the cost of any potential loss so great) that the best strategy is to try to avoid the risk entirely. You practice risk avoidance in daily life when you say something is “not worth the risk.”
Sometimes, risk can be reduced. For example, installing an automobile anti-theft device or home security system is a strategy to reduce the risk of loss.
Risk Transfer and Risk Sharing
Insurance is a method that allows you to transfer risk you cannot afford, or choose not to accept. Since you may be unable to afford to rebuild your home in the event of fire, for example, you may choose to transfer that risk to an insurer by purchasing a homeowners policy. Even in situations of risk transfer, it is common to share some risk. For example, the deductibles and premiums you pay for insurance are a form of risk sharing—you accept responsibility for a small portion of the risk, while transferring the larger portion of the risk to the insurer.
Consider these other important insurance options. Between the ages of 25 to 35, for example, many couples are just starting out—getting married and establishing families and careers. During these years, the death of one partner could seriously jeopardize the surviving spouse’s or family’s financial future. In such situations, life insurance can be used to help create an “instant estate.” A life insurance policy death benefit can help provide a continuing source of income, pay off a mortgage, or help fund a child’s education.
Additionally, many people give little thought to how they would handle financial responsibilities, such as mortgage payments, car payments, college tuition, and utility expenses, if their income suddenly stopped for an extended period of time. Disability income insurance can help replace a portion of income, should you experience a disability.
Taking a closer look at different types of risk that may affect your family can help you answer some important questions. What should I insure? What type of insurance do I need? How much coverage should I purchase? Remember, the fundamental rationale behind all forms of insurance is to determine what risks can be shared or transferred on a cost-effective basis.
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