Insurance and risk management


No one knows exactly what the future holds for us.

This isn't necessarily a bad thing. Life would be boring if we knew exactly what lay ahead. Uncertainty also creates opportunities.

But in many situations, uncertainty is synonymous with risk.

We can’t tell the future, but we can take steps to reduce the probability and impact of bad things happening.

It’s especially important to do this for risks that could be catastrophic for us or our loved ones.

There are many ways to manage risk. For example, we can eliminate risks. (This is one of the reasons men stop dying and hurting themselves in such high numbers after they reach their mid-twenties: they stop doing "stupid bachelor tricks".) We can reduce the likelihood and potential severity of health issues by getting physical activity, eating well, and not smoking.

We can also outsource risk. When we take out insurance, we pay someone else premiums to take on a risk on our behalf.

When we take out insurance, we are basically pooling our risks with the risks of many other people. The insurance company organises this, and on aggregate will usually end up ahead because the premiums the insurance company will receive will exceed the total amount they need to pay out. And the best case for most people is to pay premiums and never make a claim – because it means nothing bad happened to them.

But many people also need to claim, and receiving the proceeds from an insurance policy can benefit them and their loved ones substantially.

Bad things happen to good people. Unexpected and unfortunate things happen to people every day.

For some risks, insurance is extremely valuable.

Self-insurance

I’ve mentioned three of the main ways of managing risks: eliminating; reducing; and outsourcing. A fourth one is retaining the risk.

Sometimes, we can be aware of risks, and decide to just accept them. Instead of paying for someone else to take the risk, we “self-insure”.

For example, extended warranties sold with many consumer products are a form of insurance. You’re paying someone else to take on a risk. In most cases, the best financial decision is not to pay for the warranty, and take on the risk yourself. If a TV dies after two years, it might be a setback, but it won’t be catastrophic. In this case, you’re self-insuring.

As you build wealth, and your dependents become less financially dependent on you, you should find that you can afford to self-insure in relation to risks that you may have had to insure for in the past.

Think of it this way: Bill Gates doesn't need insurance, because if anything happens to him, he and his loved ones will be just fine.

Not all risks can be insured against

We face many risks in life that can't be insured against. These include career or professional risk; risks associated with our relationships; risks associated with investing too aggressively, not aggressively enough, or not saving enough. There are are also extremely low probability risks that doomsday preppers like to prepare for. These types of risk are outside of the scope of this course, but you may be interested in a couple of articles from the NZ Wealth & Risk blog:

In short

Insurance is a useful tool for managing catastrophic risks. The best, and most likely, scenario is that you’ll pay premiums to someone else and all you’ll ever get in return is peace of mind. But if the worst happens to you, you’ll know that you’ll be covered.

If you’re interested in hearing more, check out one of the episodes from my podcast, titled “Insurance – putting it into context”.