How to think about insurance – using logic

Here’s how you should think about insurance.

First think about the severity of the risk you are protecting against and secondly consider the possible scenarios that will occur in the future.

Severity of risk

Is the event you are insuring against likely to have a material impact on your finances and life?

For example, many people insure their mobile phones. Why exactly? If you damage or lose your phone it’s hardly going to alter your financial wellbeing or your life.

Sure it will be incredibly annoying and inconvenient, but just put your hand in your pocket and buy a new one.

Over the course of your life, the insurance premiums you pay for cover will outweigh how much you will receive for damaging or losing your phone.

With these small risks, you are far better to simply save your money and self-insure.

Larger risks however are the areas you should focus on. If you have a growing family and a large mortgage, can you really get by financially if you die, become incapacitated, or suffer from a critical illness?

These are huge life altering events for you and your family, and it’s highly unlikely that you will have the personal financial strength to withstand these impacts.

Now that you have decided about what types of financial risks you should be protecting, you can consider the following scenarios to assess what could occur, before deciding what a prudent and sensible person would choose.

Possible scenarios

1.No premiums; no claim required

You don’t pay for any insurance and you don’t suffer from any severe illness or early death.

This is the best scenario. The scenario we all wish for and financially the best outcome. You don’t have to give any money to insurance companies, don’t have to fill out any paperwork and your family’s finances do not suffer.

Unfortunately, you’re basing your future prosperity on luck, rather than judgment.

You are therefore failing to create any financial plan and you aren’t taking control of your own wealth.

2.Premiums paid; no claim required

You pay for insurance premiums and you don’t suffer from an illness or early death.

In this scenario, you have only lost the total sum of your insurance premiums. However you can rest easy knowing that you acted prudently and that the majority of these premiums would have gone to others who took out insurance but needed to claim.

Paying for insurance and not claiming feels like a waste of money but it really isn’t.

You could view these contributions as a charitable gift. Most of your money has gone to help out other families who have taken out cover and needed to claim.

So take comfort in the fact that as well as acting sensibly, you have helped others in acute financial need.

3.Premiums paid; claim required

This scenario is the whole point of you taking out insurance. You pay for insurance premiums and you also need to claim.

You pay a small premium and receive a larger benefit to offset the financial impact of negative health related occurrences.

You have basically paid for a service and that service has been provided in a timely manner to help out your family’s financial position and maintain some level of prosperity.

4.No cover; claim required

In this scenario you don’t have any insurance but suffer from a severe illness or early death.

Unfortunately as you have no cover, you have no way of offsetting the financial impact caused by your severe illness, or early death.

Your family would therefore need to get by with reduced prosperity and possibly even financial hardship and poverty.

Conclusion

These are the only four scenarios available to you in relation to insurance.

Option one is basing your future on luck and option four would be devastating to your family’s prosperity.

Looking at it logically, options two and three are the only ones that make sense and therefore you should act sensibly and take out insurance to cover the major financial risks that can and do happen.

It’s the foundation of a good financial plan.