Fire, auto accident, earthquake, hurricane and death. These might make for an exciting movie, but are not generally subjects for in-depth personal reflection. Especially if we mean thinking about these disasters happening to us or our loved ones! This may be why many savvy investors and fiscally responsible individuals don’t spend much time contemplating their insurance coverage and whether it is appropriate, sufficient and up to date. Working with our clients, we have found many people bought insurance years ago only to forget about it. Whether it was life, home, umbrella, or many other forms of insurance, we have found people generally do not put the same care into monitoring their insurance policies as they do other aspects of their financial life.
Despite the discomfort that you may feel in dealing with the negative possibilities that may be in your future, insurance is a critical component in managing wealth. Without carefully selected policies, even the healthiest and wealthiest people can have their lives turned upside down and wealth destroyed. We believe it is important for every individual to understand exactly what insurance is, why you need it, how to evaluate and select the correct type, as well as how to avoid some of the common pitfalls.
Insurance, in its most basic form, is a risk management tool. It is meant to protect against potential catastrophic loss that could be devastating. The essence of the insurance business is that a large pool of people pay a premium to an insurance company and in return, the insurance company guarantees to pay you in the event that some event occurs resulting in loss. These guarantees are based on conditions contained in the contract between the insured and the insurer. For instance, think about life insurance. If you had kids and were the primary wage earner in your family, your early death would be a significant financial hardship to your entire family. To protect against this happening, you pay a monthly premium that in the event of an early death, the insurance company will pay to your beneficiaries an amount that will cover the loss of your income, depending on the conditions of that contract.
The life insurance example clearly articulates one example of why you need insurance, but since there are many types of insurance, there are many reasons you might need it. Below are common risks people insure themselves against:
- Loss of income
- Debt repayment
- Health expenses
- Business partner’s death
- Liability for accidental harm to others
You almost certainly face at least one of these risks, if not more, on a daily basis. Ignoring them is not a wise move. In many situations, transferring the risk using insurance is a prudent decision. Common types of insurance include: life, short-term and long-term disability, health, homeowners, auto, and umbrella. While most people may be aware of their health, homeowners, auto, and umbrella policies, we find life and disability coverage are likely to be ignored. Therefore, we will discuss in greater detail the importance of reviewing these types of policies and insurance needs as changes in your life take place.
Examining the type and amount of life insurance you should have can be a complicated process. It generally should involve your financial advisor and lawyer coordinating your estate plan, and should include an analysis of the income that will need to be replaced in the event of your death. Having looked at hundreds of life insurance policies for clients, we often discover a few common errors. One of the most common mistakes is failing to select the most suitable type of life insurance for your given goals and circumstances. Speaking with someone who has a good grasp of your entire financial picture and is not compensated solely on the insurance you purchase from them should serve you well. Being able to articulate your needs will help you sort through whether you should purchase whole life or term, and from there, the amount and time you will need the coverage. In the end, out of all the policy types available, you should have a policy that suits you best.
Another common mistake is buying too little or underinsuring. The National Bureau of Economic Research released a paper in 1999 that found that based on data from the 1992 Health and Retirement Survey, almost one third of wives and more than 10 percent of husbands would have suffered a decline in living standards of more than 20 percent if their spouse had died in 1992.1 Death in the family is challenging enough without the survivors having to struggle with managing to move forward with a lower level of financial wellbeing. Some people use life insurance to try to replace all the income lost, while others insure for a smaller amount that is meant to allow the surviving spouse time to heal and transition back to work if time is needed away. Whether you have a current life insurance policy or have never considered one, life insurance is a conversation everyone should have with their advisor. Depending on your current stage of life, a lower policy amount may be more reasonable rather than a higher one.
Caution should be applied in considering a whole life policy. These types of policies are more expensive and in turn, offer a higher compensation to the agent selling you the policy. It could be that whole life policy may be an appropriate solution given your circumstances, but that is why it is extremely important to have your advisor review the policy so that you can consider what will be the best product for you, given your specific circumstances.
Another type of insurance often offered through employer benefits is short-term and long-term disability. Do you know what percentage of income the policy replaces? Do you know what the policy considers income? Do you know how long you need to be disabled to start receiving the money? These are all questions you should know. It only takes one accident. You have probably told yourself, “It won’t happen to me.” I will agree, the odds are low, but what if it does happen to you? What if you are disabled to the point that you are unable to work and you do not have short-term or long-term disability or it does not replace a large percentage of your income? We recommend speaking with your human resources department to obtain a copy of the policy and to understand what it means in your situation.
Insurance is a key component of your wealth management plan. It protects you from low probability events that could shatter the wealth you have taken a whole lifetime to build. You should review existing policies any time a major life event, such as the birth of a new child, purchasing a new home, or starting a new job occurs. Even absent major changes in your circumstances, a review every few years is wise, and can assure that the insurance values are appropriate to protect your family and your wealth.
If you have questions about your insurance policies, we recommend you speak to your Empirical advisor and ask how your existing policies fit in the context of your own wealth management plan.