The Role of Insurance in Your Financial Plan
Jay Abolofia, PhD, CFP® is a fee-only, fiduciary & independent financial planner in Waltham, MA serving clients in Greater Boston, New England & throughout the country. Lyon Financial Planning provides advice-only comprehensive financial planning for a flat fee to help clients in all financial situations.
Your financial plan is only as good as it is secure. In what follows I layout the core financial risks you may face over your lifetime and how best to manage those risks at lowest cost.
Fundamentals of Risk Management
Risk is the potential for uncontrolled loss of something of value. A risk management strategy is the process of controlling the probability or severity of the potential loss. There are four basic strategies to managing your exposure to risk: avoidance, reduction, retention, and transference.
The figure below illustrates how best to manage your exposure to risk, based on the probability and severity of the loss. Risks with a high severity of loss, even if the probability of loss is low, are the most important with respect to your financial plan (see highlighted area). If you experience a financial loss of great magnitude, for example due to a premature death, long-term disability, expensive lawsuit or major property damage, your plans for the future may no longer be possible. Your objective is therefore to transfer such risks to an insurance carrier and/or avoid them, to the extent possible.
Risks to your Human and Financial Capital
You spend money over your entire life, but earn over only a portion of it. This means that your financial plans for the future rely on your ability to earn, save, and protect those savings. When you’re young, your human capital (or future earnings) is your largest asset. As you approach retirement, your financial capital (or savings) is your largest asset. This has important implications for risk management.
The figure below highlights several core risks to your financial plan and whether they impact your human and/or financial capital. The severity of each risk will depend on the magnitude of your human and financial capital and the extent to which your (or your survivors’) future spending relies on such capital. Because the magnitude of your human and financial capital change over time, the severity of loss associated with each risk type will change as well. This means your risk management strategy, including which risks to transfer and which to retain, will require modification over time.
Consider the following high severity risks:
Premature death means you can no longer earn, which may strain your survivors’ ability to afford their expenses. A sensible approach is to secure life insurance when your human capital is large and survivors’ spending relies on it. Avoid buying expensive supplemental coverage through work and apply for level term life insurance through a private insurance company. To keep costs low, ladder multiple policies to reduce the death benefit and premium as you age.
A long-term disability could mean a prolonged period of no or low earnings and higher expenses, which may strain your ability to afford your expenses. A sensible approach is to secure long-term disability insurance, especially when your human capital is large. To keep costs low, maximize your group coverage through work and pay for premiums out-of-pocket if possible. If you can’t, and/or require additional coverage, apply for a supplemental policy through a private insurance company.
A health shock or serious illness could mean expensive medical bills and a prolonged period of no or low earnings. A sensible approach is to secure a cost-effective health insurance plan, either through your employer, statewide marketplace or Medicare. To keep costs low, choose a plan with a low combined out-of-pocket maximum and annual premium.
A personal lawsuit could mean your savings and a portion of future wages are at risk of being garnished, which may strain your ability to afford your expenses. A sensible approach is to secure umbrella liability insurance, on top of your home and auto liability coverage, especially when you’re nearing or in retirement. To keep costs low, maintain coverage of roughly your net-worth plus five years of earnings.
Property damage could mean a large financial outlay to rebuild or replace real or personal property, which may strain your ability to afford your expenses. The more valuable the property, the greater the outlay. A sensible approach is to secure homeowners (or renters) insurance that covers the full replacement cost of your dwelling and personal property. To keep costs low, increase your deductibles and review the coverage every year.
Conclusion
Constructing a financial plan for your future is critical to developing sound recommendations around spending and saving. However, your plan is only as good as it is secure. Identify the core financial risks to your plan and put in place an efficient strategy to manage those risks, to the extent possible. On an annual basis, ask yourself whether your plan can withstand the occurrence of a high severity risk, like premature death, long-term disability, serious illness, expensive lawsuit or major property damage.