I Hate(d) Insurance

September 12, 2012  | By Kevin Smith

“I hate insurance.” I’ve heard many clients utter these words and I can certainly empathize with them. We often hear clients describe that paying insurance premiums feels a lot like paying rent or flushing money down the commode. Most don’t expect a return on their money and feel like the insurance company has the odds tilted heavily in their favor, much like a casino.

Many of our clients know that I lived in Florida in 2004 when one of four hurricanes hit Pensacola, Florida and brought 4 feet of water to the inside of my six month old house. According to the National Oceanic and Atmospheric Administration, severe weather caused $25.3 billion in property damages and 369 fatalities in 2004. My family and I left before Hurricane Ivan hit Pensacola, but we lost almost everything we owned. That year, I spent over $6,000 on homeowner’s, flood and automobile insurance. I remember thinking about how much it irked me to spend that much on insurance, but was glad to have it when we lost a car, the house and all the contents in both. The insurance companies paid us over $150,000 that year and we were able to rebuild. If you ever swing by my house in Austin today, most of the furniture was purchased December 2004 once I received my final payment from the insurance company. I can’t imagine what we would have done without the insurance. That experienced caused me to begrudgingly set aside my disdain for insurance.

It is natural for us to think about insurance in terms of a competition with the insurance company in which we can’t stand the idea of them winning and gathering up thousands of dollars of our hard earned money every year. At the same time, we can all agree that insurance companies serve a valuable purpose of absorbing catastrophic risks that could ruin our financial security. As your financial advocate, we ask “How can we work with insurance companies so we get a fair deal for important coverage and the insurance company makes a reasonable profit for taking on our financial risks?”

Rather than focusing on the insurance company as a necessary evil, we prefer to help our clients focus on the size and nature of financial risks and determine if an insurance product applies to cover the risk and how. This allows us to focus only on the most important insurance and get the most bang for our buck.

Let’s use the example of my house in Florida, and whether I needed all the insurance I purchased. I needed to go through a risk management process and determine the best course of action. This process works like this:

Step1: Identify potential risks and losses

When I built a house in Pensacola, I had to consider the risk that a hurricane could form in the Caribbean and impact my property. I also had to consider what I might lose if a hurricane headed my direction.

Step 2: Assess each risk

I had to evaluate the risk of a hurricane impacting my property by looking at the potential severity of the risk and the likelihood of its occurrence. Florida is a prime target for hurricanes and the impact of destruction is undeniably massive. In addition to the potential for property damage by wind, my house sat less than a hundred yards from the water. Although flood waters had never impacted houses in my area, the risk remained high. My total potential for loss was in excess of $300,000.

Step 3: Selection options to cover risks

Now that I knew the size of the risk and the probability of the risk, I reviewed 4 different risk management options:

• Avoid the risk – if I wanted to ensure that a hurricane wouldn’t impact me, then I could have chosen to live in an area that wasn’t impacted by hurricanes like commuting from Alabama.
• Reduce the risk – if I wanted to reduce my risk of a hurricane damaging or destroying my property, I could have built a house further inland or on stilts, where my risk of flood damage would have been lower.
• Retain the risk – if I thought the loss would be small or if I thought I had enough money to cover the risk, I could have chosen to self-insure by holding a much larger cash reserve.
• Transfer the risk – this is insurance. It typically costs less than 1% of the value of a home to insure it.

Step 4: Implementing your risk management options

I chose to transfer most of the risk to an insurance company because I wanted my future savings to go toward paying for my daughter’s college in a 529 account rather than sitting in my bank earning nothing. I did this by having comprehensive auto insurance, homeowner’s insurance and flood insurance. The flood insurance was painful to buy since a flood had never affected houses in my area, but the risk management process called for it – and I am glad it did.

The reality is we all face risk – the possibility of injury, illness, death or property destruction. Some losses are small, other losses are potentially devastating. For those losses that may be devastating, insurance is one of several options for limiting the financial devastation of a large loss. Following a risk-management process to determine where your risks lie and determine the most appropriate course of action.