This is an excerpt from Your Money Milestones: A Guide to Making the 9 Most Important Financial Decisions of Your Life, written by Moshe Milevsky.
An excerpt from Chapter 7: Insurance Salesmen and Warranty Peddlers: Are They Smooth Enough?
Insurance Purchases: Another Form of Smoothing Imagine there is a 0.1 per cent chance that at some point in your life you will suffer a loss (or have to pay) $1,000,000 because of some natural disaster or unforeseen accident. If this one-in-one-thousand event occurs, you will face a sudden and dramatic reduction in your standard of living. You might have to take on extra debt, accept a second job, or perhaps even file for credit and bankruptcy protection. Moreover, if you've diligently been practicing Long Division, your smoothing apparatus will be destroyed.
Now, what if I offered you an insurance policy that could protect you against this disruption? In exchange for an annual premium of $1,000, you could rest assured that if this catastrophe occurred, the loss would be covered. Would you take this policy? I would. Although my overall standard of living would be reduced marginally because of the extra $1,000 I would be paying every year, this reduction is much less painful to me than the enormous disruption from a sudden million-dollar drop in my net worth would be. (This hypothetical insurance example differs materially from the cordless phone "protection policy" because although the disruption to my standard of living represented by the payment of the extended warranty for the phone is even more trivial, the loss I would experience if that particular phone stopped working is so small it doesn't even register.)
Thus, at its core, insurance is a smoothing mechanism. However, unlike Long Division, insurance doesn't smooth consumption across time; instead, it's about smoothing across different alternative universes, ones in which you or I experience an unfortunate roll of nature's dice. In one future alternate universe, you don't get hit with the million-dollar catastrophe, and your life turns out just fine. In another, less probable, future alternative universe, you went bankrupt at the age of 40 because you were hit by the million-dollar disaster. (And you didn't insure against this risk.) So, to smooth consumption over all the alternative universes you will encounter across your life cycle, you purchase insurance to protect, or smooth, your lifestyle across all these potential outcomes.
Now, I don't believe that most people actually think this way about insurance. (If they did, no one would offer extended warranties on inexpensive consumer items, or for that matter on boats I don't own.) However, this is my recommended way of viewing the money milestone purchase of insurance.
But this "insurance to smooth" thesis doesn't imply that you should go out and insure every single possible bump or blip in any possible universe. Small losses, such as the failure of a $110 phone after two years of use, should not be insured, unless you are living in extreme poverty on $2 per day like almost half of the world population. (In that case, why are you buying a phone that costs nearly two months' wages?) The $110 loss will not cause a material disruption or unraveling of your family's smooth life-cycle plans. So, I say forget the extended warranty, do not insure against this loss, and don't waste your money on the premiums.
On the other hand, if the event you are insuring against could cause an enormous disruption to your standard of living, go ahead and insure. So, ultimately, you have to consider two aspects of every potential catastrophe. First, what is the probability this event will take place (very small, average, or very high), and second, if the catastrophe occurs, what is the magnitude of the disruption (very large, substantial, small, miniscule) to your smooth standard of living? My proposition is that you should insure only events that have a potentially disruptive impact on your lifestyle, and only if they have a relatively low probability of occurring. I'll explain more about this two-dimensional approach in a later section. For now remember the following rule for insurance coverage: Buy it for events that are both catastrophic and unlikely.
Life Insurance as a Hedge for Your Human Capital: When Young According to the American Council of Life Insurers, the total amount of life insurance coverage in force today in the United States is approximately $$20-trillion (U.S). This staggering sum of money would be paid out only if all the insured individuals died at the same time. Short of a widespread fatal epidemic or a gigantic meteorite hitting our planet, the insurance industry can safely assume that this amount will not be paid out all at once. In fact, some of this money might never be paid out at all if people stop paying their premiums and their policies lapse.Report Typo/Error