What You Need to Know about Risk and Personal Insurance
Life is full of risks. From getting in a car accident to having your home broken into, it helps to be able to financially protect what’s yours (and avoid losing money in the process).
Enter personal insurance (your safety net against financial catastrophes). Personal insurance and risk management are two sides of the same coin. Here’s exactly what you need to know about managing risk, what personal insurance is, and the different types of risks and personal insurance.
- Risk management is choosing whether to avoid, reduce, accept, or share risk.
- The three risk management rules include 1) Do not risk more than you can afford to lose, 2) Consider the odds of something bad happening, and 3) Don’t risk a lot for a little.
- Personal insurance is an umbrella term for insurance that protects what you own and your ability to cover expenses.
- Three risks that insurance companies review include personal risk, property risk, and personal liability risk.
What is managing risk?
Risk management is understanding what risk is and choosing how to deal with it. Personal insurance is a crucial way to manage risk (but we’ll get to that).
Risk is the potential for an adverse financial condition or event to occur. Here are four potential ways to manage risk:
- Avoid risk. In this case, you avoid risky activities and don’t need insurance. But this is an almost impossible way to manage risk. Accidents can happen anytime, even when walking down the street.
- Reduce risk. You can’t eliminate risk, but you can reduce it. For example, you might take a driver’s safety course to reduce your chance of car accidents on the road.
- Accept risk. Sometimes it may be cheaper to accept the cost of the risk, depending on the type. Maybe you’re willing to accept the risk and costs if your home is broken into.
- Share risk. Personal insurance is about sharing the risk. In exchange for payments (or premium), an insurance company promises to cover most costs if something personally happens to you and your loved ones.
Sharing risk through insurance can be the safest financial option in many cases. But to decide which risk management approach is right for you, follow the three rules to risk management:
DO NOT RISK MORE THAN YOU CAN AFFORD TO LOSE.
Balance risk with how much you can afford in costs. Maybe you have a $500K house. In your area, it floods every twenty years. Can you afford to replace your house if it does flood?
If the answer is no, you probably need to purchase flood insurance to protect your home.
CONSIDER THE ODDS OF SOMETHING BAD HAPPENING.
Determine how likely it is that something bad will happen before purchasing a specific type of personal insurance.
Let’s go back to the house example. Say that instead of every twenty years, your area floods every one thousand years. The chances of your home being lost in a flood are pretty low. As such, you probably wouldn’t need to buy flood insurance.
DON’T RISK A LOT TO SAVE A LITTLE.
In other words, don’t skimp on costs in the face of high risk and have enough protection. Maybe you decide to purchase fire insurance to protect your house. You know the odds of fire exist. Is it reasonable to pay $300 a year when your house is worth $500K? In this case, the cost of fire insurance would be appropriate to avoid risking your entire house.
By following these three rules, you can better manage risk and decide if you need personal insurance.
What is personal insurance?
Personal insurance is an umbrella term for insurance that protects your assets or what you own, and your ability to cover expenses. Personal insurance can literally keep you from financial ruin. Examples include auto insurance and health insurance.
Here’s how it works: you buy an insurance policy and agree to pay the insurance provider a set amount of money periodically. This payment is known as a premium. In return, the insurance provider promises to help cover costs or pay you back if something bad were to happen, such as to your car or home.
Here are three risks that insurance companies review (and what type of personal insurance you’d need to guard against each one):
1. Personal risk
Like or not, bad things happen. You personally risk experiencing
- Poor health
- Long-term care
You might also live longer than you expect, which comes with costs of its own.
Personal risk is the potential of losing your ability to make money. This is where certain types of personal insurance come in to protect your ability to make money.
Employer health insurance is one type of personal insurance. Long-term disability insurance is another example. With a long-term disability, you might not be able to work again. Disability insurance goes a step beyond health insurance and helps you cover daily expenses if you become disabled.
And according to the Social Security Administration, one in four new workers will become disabled and unable to work before they reach retirement age. Disability insurance can be invaluable for this personal risk.
2. Property risk
Property risk is the risk of damage to your personal property. Property risk includes:
- Real property (e.g. homes, real estate)
- Personal property (e.g. cars, clothing)
Property insurance is a personal insurance policy that protects both types of properties and offers financial reimbursement for damage or theft.
Let’s start with real property. If you’re a homeowner, your house is likely the biggest thing you’ll buy. To cover any damages if something happened to the house or what’s inside, you can protect your investment with homeowners insurance. This type of insurance gives you peace of mind.
If you’re a renter, you can also purchase renter’s insurance. If you rent a property like an apartment or house, renter’s insurance protects your personal belongings like your clothes and valuables from events like fire or damage from a vehicle. This insurance may also cover temporary expenses like hotel bills if the home becomes uninhabitable (such as leaving because of extended repairs).
Your car is likely your second largest purchase. Auto insurance protects you against financial loss if you experience vehicle-related accidents or theft. You pay a premium or a monthly cost to the insurance company in return for their coverage (including medical payments) if something were to happen. Almost all states require some level of auto insurance.
3. Personal liability risk
Personal liability is the risk you’ll need to protect yourself from someone else.
This happens when someone believes you are liable for something and they come after you (hello, expensive lawsuits and settlements). Car accidents are included in this risk, as well as being liable for property damage such as to a rental property. But there are other examples.
Say someone was injured on your trampoline or your dog bit them. They might decide to sue. You then might lose personal assets (i.e. everything you own) as you struggle with legal fees and actions.
That’s personal liability and there’s always a risk of this. Personal liability insurance (a component of homeowners or renters insurance) helps protect your personal assets. It covers potential lawsuits, property damage, and bodily injuries.
You can also purchase something called an umbrella policy or personal umbrella liability insurance. This insurance covers any costs not protected under your liability coverage from things like serious car accidents or accidents on your property.
Protect yourself through personal insurance
When it comes to your personal finances, we recommend following the GAP approach:
- Generate or make money.
- Accumulate or save money.
- Protect your money.
Personal insurance is crucial to the “P” in GAP to protect what you have and ensure a stable financial future.
Want to learn more about insurance and personal finance? Check out Personal Financial Well Being on Udemy. Section 9 and Section 10 take a deep dive into personal insurance and protecting what you have. Sign up through our link!