An easy-to-understand explanation of what insurance is and why it is essential to your financial health.
Few things can strike true fear and loathing into the heart of the average citizen: purchasing a used car, filing income taxes, serving jury duty… but right at the top of this list of mundane and often aggravating activities is dealing with your insurance policies.
However, insurance is more important than you think—it is the cornerstone of any solid financial plan. What follows is a bit of insight into the ho-hum world of insurance, what it is and why you need it.
What is insurance?
Simply put, insurance is the transfer of risk. Everything we do, each item we purchase carries some inherent risk—the house could be blown over in a windstorm, your brand new computer might be stolen, you may even break your leg playing a pickup soccer game. Each of these instances poses a quite difficult and potentially financial-draining scenario, enough to make you think that the bubble boy was onto something.
Unfortunately, most of us are unable to live our lives encased in plastic, protected indoors from all peril. That’s why insurance exists—to hedge against the risks we and our property face. By transferring these risks to another party, financial and potentially emotional damage can be minimized.
Why does it matter in your financial plan?
Most insurance is not required by law, thus consumers mistakenly assume they really don’t need it. Another expense to cut in difficult times, right?
Wrong—not having the insurance you need is one of the quickest ways to guarantee financial ruin. You can scrimp, save and earn your way to being a millionaire, only to have an unexpected catastrophe ravage your wealth in an instant.
It’s easy to overlook your insurance needs because the benefits are not immediately tangible. But all it takes is one major hiccup to prove the value of your policies.
So how does it work exactly?
As stated earlier, insurance is simply the transfer of risk from one party to another, in exchange for a premium. You may not want to assume the financial risk associated with owning a house, car, etc., but there are companies out there that specialize in this—these are your insurance providers, to whom you pay a premium for taking on your risk. Should an event causing a loss to you occur, the provider will reimburse you accordingly.
In its simplest form, insurance can be related to a form betting. For example, let’s say ABC Insurance Company sells a policy to the Smith family, protecting their home. The Smiths pay X dollars to ABC a year for the insurance coverage. ABC knows that the odds of them having to pay the Smiths for damage incurred is fairly low—houses don’t normally suffer total losses, except for the most unique circumstances. Thus, in exchange for X dollars a year, ABC is “betting” that no damage will occur to the home.
If it sounds a bit risky, it’s because it is—that’s why insurance companies make sure to have lots of clients, in order to minimize the impact of a single financial loss.
Now that you understand a bit about how insurance works, it won’t induce as much groaning as it may have in the past—after all, it is an essential part of any personal financial plan.