Where did insurance come from? Before there were large companies, insurance was handled within a community. If a person needed something in a community or a person had a disaster, the rest of the community would band together and provide for that person what was difficult for them to do themselves. Examples are rebuilding the barn after a fire, or taking care of someone who was disabled. As communities got larger, this service was provided by companies rather than communities to spread the risk among more people, and to have a larger pool of resources to handle larger problems. If a typhoon wiped out a community, help would have to come from outside the community to rebuild. There may not be enough money or resources to pay for this kind of help. Where this idea gets interesting is trying to provide this service for profit. As in any business, costs exist to pay staff and overhead, and to handle risks like people not paying, regulations or unexpected events. Back in the days of the community, there was no profit motive as everything balanced out in the end for everyone involved.This article is written to gain a better understanding of the dynamic of the insurance world, so that someone can know what questions to ask with respect to insurance. There are a number of things to remember when balancing the ideas of insurance, profit, risk, needs and time. Two additional factors to consider are taxes and investment options. This article does not cover all aspects of insurance, but it serves to get the reader to ask questions and understand what value insurance is providing.Profit on AverageProfit will always be made somewhere by the insurance company on average. This means that if 100 people have fire insurance, and one person’s house burns down and claims it, the insurance company will pay the claim and still be solvent. If 20 people have their houses burn down, there may be enough to pay all of the claims, but solvency may be at risk. If all 100 people make a fire insurance claim, the insurance company would likely go bankrupt. If the average claim for a certain event stays the same, and there is money to be made based on this average, then the business can be sustained as long as this is true. If this average suddenly rises, then the profitability would fall, or the converse would happen. Insurance companies will always endeavor to make money. In terms of claims, it depends on how many claims there are, how much they cost and who gets to the pot of money first. The customers who make claims first in a group of claims will make more money than the average. The customers who make claims last may find that there is little money left for them.Risk and ProbabilitySince an average is what is being dealt with, the risk or probability of someone making a claim would be examined by an insurance company for each type of event – in this case a fire. If the probability of an event is so low that it only happens every 1000 years, then insurance may not be valuable to the customer. If an event happens once or twice in a lifetime, it is likely you would have to insure against it. Every event will have their own average, which is why companies will not cover certain events but will have no problem covering others.Amount of a ClaimGoing hand in hand with the probability and risk of an event happening is how much an event or claim costs. If you are insuring against nuclear war, and a war does in fact break out, the damages could be huge. The cost of settling this claim could be large enough to soak up all of the assets of the insurance company. A balancing question to ask is “if there is a nuclear war, will I survive it? Will I care about having insurance?” The answer is likely no, so insurance against nuclear war is not a great idea. If the cost of a claim is small, there can be many more claims made with few issues of being able to pay for them.What Are Your Needs?Needs refers to your actual needs as the client. These actual needs should be weighed against your fears or perceived needs. If you believe you will have a house fire every 20 years, and this is what typically happens on average, then fire insurance will be a need for you. If the average person has a house fire every 100 years, but you tend to have a house fire every 20 years, then fire insurance is more of a need for you compared to the average person. If you have a house fire every 100 years, and the average person has one every 20 years, insurance will not be as critical for you as for the average person. If you believe that you may have a house fire but your experience shows that you have never had a house fire, are your needs justified for insurance or is this paranoia? Conversely, insurance can also represent peace of mind. Even if you likely will never need to use the insurance, the fact that you can sleep easier would be worthwhile just for the psychological benefit from having not having to worry about a house fire.TimeAnother component to think about with insurance is time. Money given to an insurance company will not sit in a bank account. It will typically be used to make money somewhere else. If this is being done prudently, there will be ample funds available to pay for claims. If the money is not invested properly, will the money be there for a claim? This is like the bank run situation – will my money be at the bank if I want to withdraw it? Having no money for claims is rare, but it does happen with large disasters. A large disaster is an insurance company’s “bank run”. If it is true that they are investing money and earning interest, can you do the same thing and get some of that reward by holding the money yourself? In some cases the answer is yes, but in other cases this will not be possible due to the possibly huge size of a claim, like an auto accident lawsuit. The longer it takes for a claim to come to fruition, combined with how much the claim costs, can be balanced against whether you can put aside money yourself to pay for a future claim. If the amount of a claim is small in amount, doing it yourself is possible. In the case of large claims, having insurance is a better idea.Tax Benefits and InvestmentTax benefits are referring to insurance products that allow the payouts to be tax free. This benefit can be useful for passing wealth to the next generation and other estate planning strategies. Investments can also be utilized with insurance products to make interest tax deductible, or to have tax deferred growth on your investments which can supplement the RRSP, LIRA and TFSA products. This type of insurance fulfills the needs of coverage against some future event, but also serves as an investment vehicle and a tax shelter. The value in this case should be assessed for all of the components and whether they serve your individual requirement. The needs should also be revisited more frequently because tax and investment rules change more quickly than typical insurance needs.An Example of How to Assess Insurance NeedsUsing an example of a house fire, can something happen where insurance would be useful? Yes, a house fire can happen, and a home can have expensive damage. Can a house fire happen in my lifetime? Yes, definitely. What are the odds that it will happen to me? You can examine typical house fire causes like smoking, candles left unattended, cooking fires, faulty wiring or carelessness with flammable liquids. Do any of these causes apply to me? If the answer is yes, insurance is a good idea. If none of them do, a house fire will be very unlikely. Can I save up enough money to pay form damages should a fire occur? If you own the house, replacing your house in its entirety may not be possible for you to do unless you are very wealthy. If you are renting, and what you are insuring is not worth very much, having a lot of insurance is not going to benefit you very much even should a fire occur. If insurance is purchased and a claim is made, will the insurance company pay? This is a difficult to answer question, but here are some parameters to think about. Does the insurance handle its investments well? If it does, there will be money for claims. If not, the opposite is true. Do they have a history of paying claims without issue? If yes, having a claim satisfied is more likely than not. The best way to find this out is to talk to people who have actually filed claims with your insurance company and see their experiences. Ideally the claim that was paid out should be identical to the one you are insuring against. If there is a scenario where the whole city is on fire, and everybody claims, will I get paid? This scenario is extremely unlikely, but it may be actually happen for insurance against earthquakes, floods or windstorms.Insurance is a necessary and versatile tool not only for insuring against events, but also to create other benefits like tax deferral and investments. Each type of insurance should be analyzed for your needs and the benefits provided to you.
“Do I need life insurance?” “Is whole life insurance a good investment?” “Is term life insurance risky?” Questions like these are posted in online communities on a daily basis. The answers vary widely, with the term life and whole life camps polarized. The tone of the debate is surprisingly strident. After all, the topic is insurance–not a something expected to inspire strong opinions, let alone strong language. But words like “rip-off,” “scam,” and “waste of money” fly back and forth, sometimes accompanied by rows of exclamation marks or worse. What is behind the brouhaha? And which camp -if either – is right?The two sides do not even agree about whether a person needs life insurance. Whole lifers say, yes. You do not want the death of a family member to disrupt your family’s finances or jeopardize its future. It is hard enough to adjust to the loss of a loved one. Adding financial difficulties exacerbates the problem. With the skyrocketing costs of funerals, even children and seniors should have at least a small life insurance policy.Not so fast, say the term lifers. The only reason to have life insurance is to replace the lost income of a family member who dies, and then only when the spouse or family is dependent on that income. If you are single with no dependents and no debts that might be transferred to your family in the event you die, then you do not need life insurance. If you are married and your spouse works, you probably do not need life insurance, either, assuming your spouse makes enough to support himself or herself.The time for life insurance, term lifers say, is when the policyholder’s income is vital to the financial security of the family. If, for example, you have purchased a home together and your spouse could not pay the mortgage and other bills by himself or herself, then life insurance is in order. If you have children, you will want to have enough life insurance to allow your family to maintain its lifestyle after you are gone. This includes not only meeting day-to-day expenses, but also being able to follow through with plans for higher education. Insurance professionals recommend buying a policy with a face value 5-10 times the breadwinner’s annual salary to help family meet expenses for a period of years.Whole lifers see problems with the term-life scenario. The view it as overly optimistic, even naive. Many things can happen during the 20- to 30-year period covered by term life insurance policy that could extend the need for coverage beyond the policy’s end date. For example, children may be born mentally retarded, with severe autism, or with another serious condition that could prevent them from becoming independent when they reach adulthood. Children also can develop a disease or suffer an accident that disables them. A spouse, too, can become disabled. In these situations, the family will remain dependent on the breadwinner’s income long after the term life policy expires.Term life insurance advocates point out that in such cases, the breadwinner can renew the term life insurance policy, or take out a new one. Now it’s the whole lifers’ turn to say, “Not so fast.” By the time the second term life insurance policy is needed, the breadwinner will likely be in his or her fifties or even sixties. Due to the age of the insured, the cost of a second term life insurance policy will be much higher than the cost of the first was.
With the added years come added risks of certain diseases. If the breadwinner is obese, has developed high blood pressure, a heart condition, diabetes, or another disease, the cost of the term life insurance policy will skyrocket. If the individual has developed cancer or AIDS, he or she may not be insurable at all. In such situations, the cost savings realized on the first term life policy could be wiped out by the high cost of a second term life policy.By contrast, the premiums of a whole life policy are set for life and do not go up with age or medical condition. A whole life policy cannot be canceled due to medical conditions, either. The policy remains in force until death, as long as the premiums are paid.”Until death” is another advantage of whole life, its advocates maintain. Whole life gets its name from the fact that it insures the policyholder life until death. As a result, whole life insurance is guaranteed to pay a death benefit-the amount the policy pays upon the death of the insured. The death benefit can be increased-at certain points at no additional cost-as the policyholder ages. A small policy designed to cover the funeral costs of a child can be increased to provide adequate coverage during an adult’s peak earning years. Whatever the death benefit or “face value” of the whole life policy, the insurance company guarantees to pay it. As a result, the policyholder or his or her beneficiaries always receive some, all, or more than the premiums paid into the policy.This is not the case with a term life insurance policy, whole lifers point out. The term life insurance policyholder can pay premiums for 30 years, but if he or she outlives the policy-even by a day-then all of the premium money is gone. The only thing the policyholder will have received is 30 years worth of peace of mind.Whole life insurance, by contrast, accumulates a value that the policyholder can access during his or her lifetime. This value is known as the cash value or the surrender value. The whole life policy holder can use the cash value as collateral for a loan, or even borrow some of it during his or her lifetime. The policyholder must pay this amount back. If he or she dies before it is paid back, then the unpaid amount is deducted from the death benefit. If the policyholder decides to cancel the policy, the insurance company will pay him or her the cash value, which is then known as the surrender value. Whole life, its proponents maintain, is not only insurance against death. It is an investment for life.This is where the debate turns nasty. Term lifers often ridicule the investment features of whole life. Because whole life always pays a death benefit, it costs 5-10 times more than term life does. Term lifers argue that a person is much better off getting a term policy for the same face value that they would get a whole life policy, then saving and investing the difference in premiums. Almost any investment will return more than a whole life policy will, term lifer proponents maintain. Over 20 or 30 years, the difference can be vast. Buy insurance to insure, the term lifers say, and use the savings to invest.Whole lifers respond that the return on a whole life policy is guaranteed at the outset, something than cannot be said for other investments. To earn greater rewards, the term life policyholder must take greater risks in the open market. Many investments will outperform whole life insurance, but not all will. Some investments lose money, as shareholders in World Com, Enron, Peregrine Systems, and many other companies can attest.Even if the investment will pay out, it is not certain that the term life policyholder will actually make it. To do so, he or she must calculate the amount saved over whole life insurance; save that money every month, quarter, or year; research possible investments; and contribute to that investment regularly for 20 or 30 years. This makes sense for disciplined and savvy investors, but many others will find the endeavor daunting and time consuming. They may not start it, and if they do, they may not continue it. Whole life takes care of insurance, savings, and investment in one easy payment. Even if the returns on whole life are not great, saving something is better than saving nothing, and nothing is exactly how much many term life policyholders will end up saving.Both whole life and term life have pros and cons. People who are financially savvy and disciplined will gain from the term life scenario. Those who need a convenient and simple mechanism for insurance and savings will benefit from whole life insurance. Deciding which is best for you requires an honest appraisal of your goals, your lifestyle, and your investing skills.