“How Much Insurance Should I Have?” — Risk Management 101

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I woke up this morning to the sound of a chainsaw.

My neighbor John’s tree fell last night — right into his living room.

A crew was busy cleaning up the mess, but I could see that John’s house had serious damage.

When I walked over to ask John how he was dealing with it, he just shrugged:

“None of us were hurt, and I’m insured. We’re good.”

He’ll be out the cost of his deductible, and some other costs may pop up. I wouldn’t be surprised if he and his wife use this as an excuse to upgrade their furniture, for example.

But, other than the downer of losing a 75-year-old tree, he didn’t have a whole lot to worry about.

This got me thinking about insurance — specifically about how much insurance it makes sense to carry.

It’s possible to be underinsured. That puts you, and your family, at risk of being wiped out if tragedy strikes.

But, contrary to popular belief, you can also be overinsured — wasting money you could better spend or invest elsewhere.

Before we talk specific numbers, let’s get philosophical.

Insurance Only Makes Sense If…

Insurance is effectively accepting a known loss — your premiums and possibly a deductible — in exchange for avoiding what could be a much more significant loss.

For example, your homeowner’s insurance bill might be a couple of hundred dollars per month. That’s a known loss. You know ahead of time that you’re paying it, and you do so to protect from a potentially devastating loss were your house to take heavy damage.

But here’s the deal: Insurance only makes sense if the loss could ruin you, or at least make a serious dent in your finances.

Look, my office is uninsured.

If the entire building burned down, here’s what I risk:

  • Furniture (around $1,000 worth).
  • Computer parts (another $1,000).
  • My library (no real monetary value).

You see, it’s harder to put a dollar value on my library since my books have sentimental value. I’ve collected my books on four continents over two decades. But if they burned in a fire or blew away in a tornado, I wouldn’t be able to replace them, even if an insurance company wrote me a check for their purported value.

In the case of my office, insurance makes no sense. I could replace it on a shoestring budget within a couple of days.

Why have yet another monthly payment to protect a bunch of junk that isn’t that valuable?

Car Insurance

Of course, I have liability insurance on my car because it’s required by law — and because I have no good way to calculate my risk.

If I accidentally sideswiped a Rolls Royce and ran it off the road, I could be liable for hundreds of thousands in damages.

It’s better to pay Geico a modest monthly payment to avoid that possibility.

But I declined full coverage. My car is paid for, and it’s pretty much a jalopy after carting around two young boys and a baby girl through their formative years.

If I totaled my car tomorrow, I would just buy something newer. It wouldn’t be a major financial burden.

Homeowner’s Insurance

My home, however, is a different story. It’s fully insured.

Sometimes, I think it would be a godsend if the thing burned down. It’s been a money pit since I bought it. But if that happened, I’d still have a mortgage to pay, and I would potentially lose a couple of hundred thousand dollars in home equity. Insurance protects me from that.

All the same, I have the highest deductible my insurance company allows because it means a lower monthly payment. I’m happy to accept the risk of minor damages in exchange for that lower payment.

I use the money I save on insurance to pay down my mortgage faster, building my wealth.

How Much Insurance You Really Need

And at what point does it make sense to “self-insure” or simply accept the risk of being uninsured?

There isn’t a firm number here. It’s more of a subjective feeling.

My rule of thumb is the “sleep at night” test. Can you comfortably sleep at night after considering your potential losses if the worst happens? Then you’re probably fine.

But I’ll try to make that more concrete.

Look at your current savings and ask yourself: “How much of that am I willing to risk?”

If an uninsured motorist totaled my car, I’d need enough cash on hand to make a down payment on a new car. I’m good with that.

If you’re not, then you should have full coverage on your car.

Likewise, I’m comfortable eating several thousand dollars in health expenses or home damages.

My pain threshold is about $7,000 to $10,000. That’s when I start to sweat a little. So, I should have insurance that protects me after a deductible around that amount.

And your number might be higher or lower. There’s no “right” answer here.

The Same Is True of Life Insurance

I want to have enough life insurance so that my wife and kids can continue to live our current lifestyle indefinitely if I croak tomorrow.

But I don’t want to have so much life insurance that they have an incentive to off me and make it look like an accident.

I’m joking — sort of.

All the same, it makes no sense for me to make massive life insurance premium payments for a huge death benefit when I could take that same money and invest it elsewhere.

Every dollar you spend on unnecessary insurance is a dollar you can’t spend elsewhere.

So, this is my advice to you:

Assess your assets honestly. Look at what you’re paying (or not paying) for protection. Does it make sense? Or are you spending far too much money to protect something that’s not all that valuable?

If you have a healthy pot of savings built up, don’t be afraid to self-insure — if you’re comfortable doing so.

Paying too much in insurance isn’t as potentially devastating as paying too little, but it is still detrimental to your wealth.

It slows down growth and takes away from other potential investments that could bring in more money for you.

 

Money & Markets contributor Charles Sizemore specializes in income and retirement topics. Charles is a regular on The Bull & The Bear podcast. He is also a frequent guest on CNBC, Bloomberg and Fox Business.

Follow Charles on Twitter @CharlesSizemore.

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