Personal Finance Concepts You Should Know – Concept 3: Insurance

River1Understanding insurance it critical for managing your finances.  Some insurance products just aren’t worth the price.  Others are critical to have during different periods of your life or you could find yourself destitute.  Here are key concepts to understand:

What insurance is

Let’s say that you lived on a street with 100 houses.  You noticed that, on average, there was one house fire every ten years.  You and your neighbors might get together and decide to put some money together to pay for someone’s house if there is a fire (provided, of course, that the fire was not intentionally set).  If each of the homes cost $250,000, the amount you would need to pay out per year would be $250,000/10 years = $25,000.  Since there are 100 of you, you would each need to pay $25,000/100 = $2,500 per year to provide the money needed to pay for the house fires.  You might choose to do this since, while the chances of a fire actually happening are only 1/(100*10) = 0.1% per year, you would not have the $250,000 needed to rebuild your home should a fire occur.  This is what insurance is – people pooling together their money to pay large amounts of money to a few individuals for relatively rare events.  Insurance is generally for things you never expect to happen and usually are happy when they don’t.  Note that if you held your home for 100 years and paid the $2500 each year, you would have paid for the full value of your home.

When you add an insurance company to the scenario, things really aren’t that different.  In our example above, you might have decided to pay one of your neighbors to handle the money, including the payouts, the accounting, and the tax preparation.  In exchange, you each might pay $2750 pre year to cover a salary for the neighbor and his costs.  This is really what the insurance company is doing.  Because a fire only occurred every ten years, the manager might also choose to invest the money in the stock market or real estate so that he could make a return off of the money while it was just sitting there.  This is really where the insurance company makes their money – it is not from the premiums you pay which might cover salaries and costs but would not provide any profits to the insurance company.  If they did charge a lot more than their costs, another insurance company, knowing that they could make a good profit from investing the money, would charge a lower premium so that you would give your money to them instead.

What is not insurance

The two factors that make insurance real insurance are:  1) The event you’re insuring is unlikely to occur and 2)if the event were to occur, it would be devastating financially for you.  There are products that are called insurance, but they really are just prepaid plans.  An example of this is heath insurance.  There is a component of health insurance that is true insurance – the portion that covers you if you develop cancer and end up undergoing $1M in treatments – but most of the money you pay is just prepaid healthcare.  You pay the insurance company for the doctors visits and prescriptions that you are very likely to need during the year.  Some people use more healthcare, so they end up paying less than they cost the insurance company, while some people use less, but on average people pay what they would pay to the doctors anyway.  Actually, you pay a little more than you would if you just paid the doctor directly because you need to pay for the staff at the insurance company and the extra staff the doctor hires to file the claims.  The two factors listed above do not apply since you are likely to have the event occur (for example, you’re almost certain to have a physical each year unless you simply choose not to have one) and the event is not financially devastating (it might cost you $60 for an office visit and maybe $100 in labs if you were to just pay on your own).

When to buy insurance

You buy insurance when the event would be financially devastating.  You buy homeowners insurance since it would take you a decade or more to save enough money and buy another home should a fire occur.  You buy major medical insurance since a liver transplant would probably drive you into bankruptcy since few people have an extra $500,000 sitting around.

When to not buy insurance

You should not buy insurance when the two criteria above are not true.  If the event is very likely to occur, you should just save up money and plan to pay for it.  If the event would be an annoyance instead of being financially devastating, you should just self-insure, meaning that you’ll just pay for the event should it occur, and save your premium money.  The one exception here would be if the cost of the insurance is so low that it really doesn’t matter anyway.  For example, someone with $10 M in investments might choose not to insure a $200,000 home because he could just buy another if a fire occurred, but since insurance might only be $1500 per year anyway, it would not really matter to him if he paid for the insurance.  Yes, he would be paying a little more this way (if you look at the odds a fire will happen and the cost to rebuild the house) than he would if he self-insured.  In ten years, however, he would have only paid out only $15,000 in premiums, which is very little compared to the $6 M or so he would probably made on his investments.  If a fire did occur, he would probably feel better to use insurance to rebuild the home than he would if he had to pay cash himself.  He also might have things invested and not want to sell investments to raise the cash since this creates other expenses like commissions and taxes.

Insurance you really need

Term Life Insurance:  Before you are married and have kids, there is little reason to have life insurance and you might choose to go without.  You might also choose to get a small, $10,000 policy to pay for your funeral should you not want your parents or someone else pay to bury you and you didn’t have enough in possessions and savings to cover the expenses.  After you are part of a family, however, you have people depending on you who would be financially devastated should you die suddenly.  If you work, you need to have ten times your annual salary in life insurance so that your income could be replaced through investments.  If you take care of the kids and the home, you need to have about $500,000 in insurance to pay for a nanny and maid service should you pass.  When you are young this type of coverage will be less than $300 each per year for a 15-year term policy.  By that point, hopefully you’ve saved up enough to be self-insured.

Car Liability Insurance:  OK, you need this by law, but it would also be devastating to get into a wreck where you injure people and end up paying several hundred thousand dollars in hospital bills.  You also might end up paying for an expensive car if you hit the wrong person.  You may think you can’t afford auto insurance, but if are paying for a cell phone plan instead of car insurance, for example, your priorities are out of order.

Homeowners insurance:  We’ve already discussed the need for this.  You are required to have home insurance while you have a mortgage since the bank wants to be sure you’ll pay them back.  Once you become financially independent and paid off your home, you could go self-insured, but it really doesn’t cost that much for the piece of mind.

Major medical insurance:  Unfortunately, you can’t buy just major medical insurance anymore since the passage of the Affordable Care Act, a.k.a. Obamacare.  While you don’t really need to have insurance to cover routine care – you should just put money aside to pay for it – you do need coverage for long hospital stays.  Since it looks like Obamacare is likely to collapse, maybe we’ll get back to the point where we can just buy major medical policies.  Otherwise, electing the right people and holding them to their promises could cause the law to be changed.

Insurance you don’t need

Whole life insurance:  The returns you get from turning your life insurance policy into a saving vehicle are awful, plus you generally lose your savings account should you die and use the policy.  Skip the whole life and go for term instead.  Just stick the difference into  a mutual fund and you’ll be much better off.

Cell phone insurance:  At more than $100 per year, phone coverage just isn’t worth it.  Also note that many plans require a $200 deductible, so you could just buy a $200 phone if you drop your phone in the toilet.  (Why do people need to use their phones on the toilet?)  Just buy a protective case.  You might also consider buying a phone separately rather than getting the “free” phone where you actually pay for the phone over the next few years with higher monthly plan costs.  That way, should something happen, you won’t end up paying for the phone you no longer have for the next several years.

Routine medical care insurance:  Again, you now have no choice here, but you could help change things if you vote and express your opinions to your representatives.  You would be much better off just giving the doctor cash when you went in for your check-up.

Renter’s insurance:  While it stinks to be robbed or have a fire destroy your stuff, the chances are low and you can recover from a few thousand dollars in losses to clothing and stereo equipment.  Instead invest in a good lock, an apartment in a better part of town, and maybe a dog.  Or maybe move in somewhere the neighbors have really nice stuff.

Home warranties:  Again, this covers things that will happen eventually, so you’re paying a premium when you buy a policy.  Instead, put money away each month for the home repairs and appliance replacements that will eventually come.

Got and investing question? Please send it to or leave in a comment.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Generation Y and Health Insurance

FireAlarmGeneration Y has gotten a bad rap, and it really isn’t deserved.  OK, the students protesting for free tuition and a $15 minimum wage on campus obviously haven’t done the math and clearly don’t understand much about economics. (In order to get “free tuition,” they would end up paying more over their lifetimes in taxes than they pay now for tuition.  Likewise, a $15 minimum wage on campus would mean things would cost more and their taxes would be higher.)  And yes, there are a lot of young adults moving back home and playing the perpetual teenager, thanks in part to their enabling helicopter parents.  But on health insurance, and on other entitlement programs, they get it.

An issue Generation X and the Baby Boomers were facing is that they were getting older and needing a lot of medical procedures, but they hadn’t saved up any money.  Also, healthcare premiums kept going up because they were getting sicker and using a lot more healthcare.  One of the big issues was that there was very little personal responsibility for keeping healthcare costs down since the patient wasn’t paying for it.  So, the older generations got together and figured out a way to “fix” the system.

They saw all of those twenty-somethings who never get sick but who weren’t buying health insurance (since they never got sick) and decided that they could force them to buy expensive health insurance with all of the frills and pay extra for it so that the older generations could pay less than the value of the healthcare they were using.  To make it sound better, they would force the health insurance companies to allow their parents to keep the Gen Y individuals on their insurance until they were 26 (it really didn’t cost the health insurance companies much more anyway, because again, they rarely got sick).

So, it was thought that the twenty-somethings would agree to pay way more for insurance than they used in heathcare, so they would be paying for the healthcare used by the older adults.  The older Americans loved this because they would be not need to pay for all of their healthcare.  They didn’t seem to worry that they spent their twenties and thirties spending their money how they wished, and they were now denying Gen Y this same opportunity.  The health insurers loved this because they would be selling expensive, full-coverage insurance to everyone, including the people who would never use it, and everyone would be forced to buy it.

Except the twenty-somethings looked at the cost of the insurance and figured out that it was not worth the price.  It was better for them to just pay the penalties.  In fact, if they kept their income low, by not getting a real job, the penalty they would actually pay would not be that big – maybe a couple of hundred dollars per year.  That was way less than the thousands they would have been paying in health insurance premiums.  Furthermore, they could avoid the penalty entirely by asking for a “hardship waiver,” which the government was happy to provide since they didn’t want to lose votes of the Gen Y crowd.

So as a result, many of the health insurers are losing money by the boatload.  They’re needing to cover the older, sicker Americans who pay far less in premiums than they receive in benefits.  Without the younger, healthy Americans there to pay the bill, insurance companies are losing billions of dollars.  Because Obamacare requires that the insurance companies cover everyone, even if a person signs up after they get sick and then drops coverage as soon as they get healthy again, they have no choice but to take on the sicker people.  Because the law also limits the amount they can charge for that insurance, there is no way for the insurance companies to break even, let alone make a profit.

For a period the American taxpayer was bailing out the insurance companies through what were called “risk corridors.”  Basically the government agreed to pay for any losses the insurers had, after those losses were offset by gains other insurers made.  Because no one made a profit, the government (meaning the taxpayers) was left bailing out everyone.  Now the risk corridor money has run out, so insurers are pulling out of the insurance exchanges to avoid bankruptcy.  As an example, United Healthcare has announced that it may pull out of the exchange marketplace next year.

Now I doubt many Gen Y individuals sat down and did the calculations, estimated the likelihood that they would get sick, what the cost of that illness would be, and then determined if the insurance was worth the money based on a risk benefit analysis.  Instead, they just had an innate sense that what they would pay in premiums was not worth it.  They realized that the chances of getting sick are fairly low, that what they would be paying in premiums over a couple of years would be more than the cost of many of the things that could happen to them in terms of healthcare needs, and decided to opt out.  Unfortunately in many cases they chose to just ignore the issue and hope nothing happened, rather than save up some of the money they would have been paying in premiums in case something did happen, which means they would burden other healthcare users with their costs should they get into an accident or something.  This leaves us exactly where we were before Obamacare, except with a lot more government employees and rules on doctors and hospitals, narrowed networks (meaning it is hard to find a doctor), more expensive health insurance since now plans must cover everyone (and because more people drop out as the price goes up), lots of more people on Medicaid with the government already $20T in debt, and doctors leaving the profession.

So how do we get everyone covered and stop having hospital bills lead to bankruptcy to the unfortunate few who do get really sick?  Well, instead of having Gen Y pay for the healthcare of Gen X and the Baby Boomers and then hope that there will be someone around to pay for them when they get sick, we should simply require that everyone start an HSA and contribute a reasonable amount of their income each year.  Because people would be putting money away for healthcare, when they got sick they would actually be able to pay their bills much more of the time, meaning the costs would drop for everyone since those who were paying would no longer be picking up the bill for those who weren’t.

On top of this, each individual should be required to buy major medical insurance – insurance that kicks in when you go to the hospital for several days – with a premium set based on the amount of money in their HSA.  Because this insurance would only pay when they had a major event, the cost would be a lot lower than the cost of Obamacare.  They would rightly judge that $500 per year or so was worth it to avoid having a $100,000 hospital bill they couldn’t pay.

Finally, we should require doctors and hospitals publish their prices for procedures where everyone could see them so that people could comparison shop.  And these would need to be the real prices – what the insurance companies actually pay them, and not the price on the books that almost always gets sliced down.  Wouldn’t it be great for hospitals to consider what would be a reasonable price for things because they knew that people would go elsewhere if their prices were too high?  This would help solve what is really wrong with the healthcare payment system – list prices are way too high, and those without insurance are forced to fight the price down on their own when they are sick, while insurance companies pay no where near those amounts, so people are forced to buy their healthcare through insurance companies even though the cost overall is higher that way than if they were to just pay on their own and hospitals just charged the real prices from the start.

Got and investing question? Please send it to or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Personal Finance Concepts You Should Know – Concept 2: Investment Risk

River1Understanding and using risk to your advantage is how you maximize your investment returns while still making sure you have the money you’ll need to eat next week.  Contrary to what you might think, you don’t generally want to minimize risk.  Instead, you want to take an appropriate amount of risk for your situation.  There are times in your life when you can (and should) take fairly substantial risks, then there are other times when you need to reel in those risks and just accept a low return for the security of knowing you’ll have the money you’ll need.

As you probably have gathered by now, you get a higher return when you take on more risk.  Now these two things are not exactly correlated – spending all of your retirement savings on lottery tickets probably won’t work out for you.  Instead, you want to take risks when the probable returns justify the risk that you are taking.  You also want to put other factors in your favor – namely time and diversification – to bring those risks down to a reasonable level when you’re investing in assets that carry more risk.

For example, if you have $10,000 that you need next year to buy a car, that money should probably go into a one-year bank CD.  Here you’re putting your money into something that has an almost guaranteed return, plus a virtual guarantee that you’ll not lose any of your principle, because you need to have the money there in a year, which is a relatively short period of time when it comes to investing.  Because you’re locking your money up with the bank for a year, they’re willing to pay you a bit more than they would if you put it into a savings account, a money market, or a shorter-term CD since they can then invest your money in ways that they could not without them knowing that they have a year before you would want the money returned.

If you didn’t need the money for ten years, however, new investment opportunities would open themselves up to you.  You could invest the money in a stock mutual fund, which have had returns of between 10-15% during most ten-year periods.  This compares with maybe 0.25% for your one-year CD.  The reason the returns are better is that the rate of return you’ll get is far less certain.  You can look at historic returns and see that most of the time your return will be in the 10-15% range if you hold for long periods of time, but over any given year or even a few years returns could be far less or even negative.

By investing for long periods of time, however, you smooth out this risk.  You don’t need the markets to do well this year or next year.  You just need to have some good years somewhere within your ten-year period.  History has shown that there may be some 35% down years, but there will also be years when a stock mutual fund will be up 40% or more.  There is also a natural tendency for stocks as a group to go up since the economy continually expands as more efficient ways to make stuff are invented.  By investing for long periods of time, you reduce your risk but still get higher returns that come from less predictable investments.

So, if you have money that you need within a year or two, it should be in cash because of the predictable return.  If you have several years to invest where you can wait for good things to happen, you should be invested in equities since they will provide a far better return.  They will also help protect you against inflation, which will decrease the value of the money you have in bank assets since the returns from even bank CDs are typically less than the rate of inflation (currently around 2%).

Now this does not mean that you should take dumb risks.  For example, stock options allow you to bet on the direction of a stock or index, and you can double or triple your money in a short period of time using them.  They have a short expiration date, however, (typically less than 3 months), so you need to be right both about the direction of the market or stock and when that movement will occur.  Making predictions such as this is about as scientific as predicting what the weather will be like in two weeks.  Given that about 90% of stock options expire worthless, and that when that happens, you lose your whole investment, stock options aren’t worth the risk.

Got and investing question? Please send it to or leave in a comment.

Follow on Twitter to get news about new articles. @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.