Today I want to begin. A series of shows relating to insurance, specifically today, I want to talk about the basics of insurance, what it is, when to have it, when not to have it, and the various types of insurance that most people will have that will unpack in later detail in future shows.
Now I know what you might be thinking. Mike really insurance. And I’ll be honest with you. There’s a part of me that wanted to get into, the path of financial success, the steps and stuff like that, but the reality is that without a solid foundation of insurance. A lot of wealth building can just be undone, frankly.
And so, if you remember back to our financial framework, we have, seven steps and two rails. So, 1, 000 in the bank, get rid of your non-emergency fund, three to six months of expenses, 15 percent going into retirement, kids college, pay off the house, build wealth and give. Those are our seven steps, all undercoated by mindset and money management.
But we have these two rails as well. That help guard us against bad things, death and incapacitation and things like that on the estate planning side and insurance or financial risks on the, on the right-hand side. So, I wanted to begin unpacking those first, because again, while it’s not super sexy and it’s not super cool, it is super important.
And so, I want to unpack insurance here. Now, again, it’s, it’s one of those two rails and those rails like guardrails on a road are meant to keep us on the road and not go off the cliff on the other side of the shoulder. But the way to also think about insurance is it’s kind of the defensive. Aspect of your financial game, right?
So when you’re building wealth, or even if you’re retired or transitioning into retirement, you are, there’s an offensive side to that, , wealth building, putting, putting points on the board, essentially getting touchdowns making baskets, shooting pucks, whatever kind of game you’re trying to play, the wealth building side, the income, the savings, the investing, the growth, that’s all putting points on the board.
Well, if you have the best offensive team, but you have no defense, you’re not going to win the game. Because while you might be putting up good record scores, if you have nobody to stop the other team the other way, then they’re gone. They can undo anything faster than you can do. And that’s true with insurance.
Insurance is the defensive side to protect us against bad things occurring in our financial lives. Really? That’s. The purpose of insurance. The purpose of insurance is to transfer risk, specifically financial risks. See, you must understand that in life, bad things occur, right? We know this. We live in a fall in the world.
No doubt about that. And not all, but some of those bad things occur, have a financial risk, right? If I’m working on a roof or something and I hit my, my thumb with the hammer, that’s a bad thing, but it might not cost financially, it just might cause some pain, some injury, some energy, things like that, but if I’m in a car.
And I hit a property that I then must pay for. There’s a financial impact to that bad event. So, the thing to remember about financial risk is that there’s an event and then there’s the impact, the financial impact of that. So, we’re not trying to, by having insurance, we’re not. necessarily avoiding the event.
We’re not trying to not have death or not have medical expenses or not have home fires, but we’re trying to do is protect the financial risk against that event when it takes place. So, to understand insurance a little bit or even more broadly risk management, we have to kind of. Elevate it to a little bit higher level.
So, if you think about the idea of, I’m going to paint a mental visual here for you. For those on the podcast on YouTube, you’ll see the chart here, but think of a two-by-two blocks, right? Two blocks by two blocks and above the two blocks are on the columns are low severity and high severity, low severity, and high severity.
So, this is the idea of. If something happens, how severe is it? And again, we’re kind of talking money. So how severe is the money impact of this event? And then on the left-hand side, if you think of across the rows, think of it as low frequency and high frequency. So. Low frequency, something that happens, very, very minuscule number of times getting struck by lightning, right?
Very, very low frequency of that. High frequency would be something that happens, all the time. Car accidents, death, death happens all the time. Might not happen to you, might not happen in your world, around you, but., hundreds of thousands of people, I would say probably die every day.
So, death is, is very common. It’s a, there’s a high frequency of it occurring. And so, with, with that kind of two-by-two scale in mind.
Let’s talk about where we would, what we would do with those risks if we’re trying management. So, if you think, we’ll start on the bottom right because that’s the easiest to understand. High severity, high frequency, right? So, let’s pretend we’re swimming with sharks, right? So, in Florida you see sharks.
They’re out there swirling around in the ocean. You’re like, hey, I’m going to go swim with them. And you engage in that, right? And the more times you do that, the higher the frequency, the higher the risk, right? So, what’s the severity? You can get eaten by a shark. That’s a high severity, right? The financial impacts of that, for others, for sure, would be bad.
Or if you just get disabled or things like that. So, what would you do if 100 people went swimming with a shark and 100 people got eaten or attacked by the shark and you’re sitting on the shore. What are the chances of you going in the water? Hopefully zero, right? Hopefully that hopefully you won’t have to be the hundred and first person to be eaten by a shark What would you do?
You would avoid the water, right? So that makes sense. That’s what you would do if there’s a high frequency of an event taking place and a high severity associated with it You would avoid that area, right? And so, you, there would be no risk to you because you wouldn’t engage in the activities, or you would stay away from it.
Right? So that makes sense. So, let’s kind of go left in the lower left block. Now high frequency, low severity. Right? So, something you do all the time, like maybe take a shower, right? Hopefully you take a shower or bath, at least a couple times a week., in Florida again, it’s hot, sweaty.
So, summertime, multiple times a day. Well, every time you’re getting out of the tub or getting out of the shower, there is a chance of you slipping. Right? And now what would happen if you slipped a little bit, you might tweak a knee, you might tweak an ankle, you might lose your balance. Obviously if you really slipped, you could fall and hit your head or something like that.
But for the most part, the, the chances of you doing major, major damage to yourself or to others getting out of the shower is relatively. Right. The severity of injury that or financial injury or injury in general that might take place would be relatively low. So, what would you do? You would retain that risk and you would try to mitigate things, right?
You would put down, in the tub, you might get those things, those mats that kind of stick, that kind of give you traction outside you would put., a towel or bathmat or something like that. So, you’re stepping on it and set it onto the tile or the linoleum. So, what would you do?
You would retain that risk and you would try to mitigate it by controlling it by putting up a handrail, things like that. So that makes sense. We wouldn’t have insurance for. Getting out of the shower and slipping, right? We wouldn’t, we wouldn’t have that. Okay. So, then we kind of go up. So now think of low frequency stuff that doesn’t happen very, very often, but low severity, right?
So low frequency, low severity. So, it doesn’t happen very often. And if it does, it’s not that big of a deal, right? So maybe like your toaster shorting out, right? I don’t know what the probability of a toaster shorting out is. I assume it would be low., Never had one. I don’t think but it could happen.
And what would be the financial impact of your toaster shorting out and not working anymore? It wouldn’t be that big of a deal. You write, you go to Walmart or Target or better yet, the Goodwill, right? Thrift store and you pick up another toaster for three, five. 30 and we got not that big of a deal, right?
So, there’s an event and there’s a financial event. The financial impact of that is relatively low. So, what would you do? You would just retain that, right? You wouldn’t, you wouldn’t do anything. You wouldn’t go buy five toasters. You wouldn’t have, certainly have insurance on your toaster. You, there’s not much you can do to protect against it, shorting out.
There are not mitigation techniques or anything like that you could do. You just must retain the risk. And if it happens, it happens. So that brings us then to the fourth category, which is high severity, low frequency. So low frequency being something that doesn’t happen very often, but when it does, it can have a very big, severe financial impact.
So again, just sticking with Florida, let’s take hurricanes. Hurricanes don’t happen that often., they happen, July to normally November timeframe. And there’s only, what, maybe 15 a year, sometimes maybe 26, sometimes they get through all the letters. But how many of them make landfall?
A very busy year would be like four or five. Of those that make landfall, how many would that hit landfall in the spot in Florida, for example, where you lived? Pretty big state, believe it or not, doesn’t look that big, but north to south is, 10 hours or so of driving. And so, the chance of you hitting it and then if it does happen, what’s the chance of it happening, do you live close to the water, things like that.
So low frequency, it’s only going to happen once every 10, years, maybe never. But when it does, but when you live within, 15 miles of the ocean in Florida and a big hurricane hit and it hits where you live. It’s a big financial deal because your house gets destroyed, right? And so, that’s where you would have homeowners’ insurance in that example, right?
So that’s where you would transfer the risk. And that’s what insurance is all about. Insurance is all about the idea of transferring the risk. The event could still occur, but we’re trying to get rid of the financial impacts to it. So, if your house gets torn up in a hurricane in Florida and you don’t have, an extra two, three, four or five, six, 700, 000 laying around to rebuild it might be a good idea to have homeowner’s insurance where somebody else will pay to rebuild your home.
And what you have effectively done is transferred the financial risk to a big insurance company that has, billions and trillions of dollars. And what did you do in exchange? You paid them a premium. All right. And so that’s what insurance is all about. Insurance is about transferring risk. Now, the reality is it’s a gamble for both sides, right?
You could pay homeowner or just stick with the homeowner’s gamble. You could pay homeowner’s policies for your entire life and never have made a claim. That’s the risks that you run engaging with that, right? You transferred the risk. The event never came. There’s no financial impact and you paid a thousand or 2, 000 for homeowner insurance.
For your entire adult life and you’ve never used it, right? That’s the risk you run but consequently you could buy a house in May You could pay June and July’s, premiums essentially two months and a hurricane could come through and destroy your house and for 500, 000 the insurance company must rebuild your house.
They got a couple hundred dollars in premiums, and they had to then pay out Hundreds of thousands of dollars to rebuild your house, bad risk for them, right? That’s the risk that they took on. And it’s a gamble that went against them. So that’s really, in the insurance world, they call that aleatory, which means it’s an unequal exchange of two parties.
Meaning really, it’s a gamble for both. We’re both taking the events that could occur and the financial impacts that like life insurance, same way, you could have life insurance for your entire life. Essentially cancel it before you die. And never has a death payment that could happen, or you could, in which case you would have lost the bet, right?
Cause you paid for something that you never cashed in on or you could get life insurance, make one payment, something happened to you the next day, die and your family gets paid out millions of dollars, right? That’s the risk that both sides are taking. So, the whole point is when you want to transfer risk is when it’s a.
Low frequency, but when it does, it’s really, high. The impact is really, high. So, there’s about six different types of areas that you would want to have insurance, right? So, health or medical, cause if you’ve ever had some or known somebody who has had some major medical things, the bills rack up quick, right?
Auto insurance, right? You can do some damage to property, to automobiles, to people’s medical conditions. Buy your actions in a car, right? So, auto insurance, homeowners we already talked about hurricanes, right? So, if you’re not a homeowner, you still have the contents inside of your property that you need to protect because your landlord can’t do it.
So, you would have renters’ insurance, which would not protect against the structure, but against the personal property inside of. The place you’re renting life insurance. Life insurance is the idea that, we’re going to die at some point. And there are, the root of it is to provide for those that are financially dependent upon you.
So, if I die, right, Erica has been dependent upon my income. I’m not, I’m dead. I can’t work anymore. And so, Erica would get money to replace my income. Right? That’s kind of the idea. People also use it for wealth building and, state planning and things like that too. So, there’s a couple other nuances to, to that.
Disability is, is the idea of protecting against wages. If you get disabled, you cannot go to work. Your financial life generally for most people is very dependent upon income coming in. If you can’t work, the income stops and so therefore so does your economic life. Therefore, disability insurance protects against disability and the loss of wages and the last one is long term care insurance, which is essentially for nursing home.
So, the stay in an average nursing home is about 200 a night. That’s 6, 000 a month. That’s 72, 000 a year. That’s a lot of money going out in in long term care needs, right? And the average stay, generally less than three years. So, if you spend three years in a nursing home 72, 000 a year, that’s 216, 000. That’s a, that’s a lot of money., that, that can, that not going to anybody else that might be dependent upon it. So, again. Life situation dictates whether you have all these things. Like, for example, if you don’t have a car, it doesn’t make any sense to have auto insurance, right?
If nobody’s financially dependent upon you, you might not need life insurance when you’re retired and your income goes away, you certainly don’t need disability, right? So, so there’s some life aspect to these things too, that., not everybody needs everything at all stages, but these are the general six that you would need.
And the things that are not on there you wouldn’t have, right. So, things like cancer insurance, you might not need cancer insurance. Extended warranties. Extended warranty. You go to Best Buy or Target or even Walmart now, and you buy anything and they, you only need an extended warranty for an extra 3 on that?
No, because again, we already talked about toasters. If your toaster breaks, you’d probably just go buy a new one. You don’t need the extended warranty on your toaster. Nor do you need it really on your TV either, or your computer for that matter. Right? So those are things that you wouldn’t, you wouldn’t engage in.
You would just get the major things you want to know where the financial impact is very, very large. So that we set the stage for insurance. We talked about the importance of it in the path to financial success when you would transfer it and have insurance. when you would not. And we began to outlay the six different types that we’re going to unpack in a little bit more detail in future episodes.
So, I hope this is helpful for you. If you have any questions, you can put them in the comments below, or you can always send an email to Mike at true out that show, and I will try to answer you to the best of my ability. And until next time, I hope you have a great day.
