Insurance is a necessity, but buying it can be complicated and confusing. That’s why I’ve developed some rules of thumb to follow when you’re buying insurance. My hope is that these will help you simplify the process and avoid buying more than you need.
1. When to dump comprehensive and collision
In short, if you drive an older car that doesn’t have much value left it might be time to drop comprehensive and collision (C&C) coverage. If you have a loan on the car, most lenders require you to carry this coverage. So check with your bank before making any decisions.
For a more specific answer, I recommend dropping C&C when its cost for a year exceeds 10% of the value of the car. Let’s look at an example. Say your car is worth $4,000. When C&C is $400 a year or more is the point when you would think about dropping it.
One important note: The point of C&C is to repair or replace your vehicle when it’s damaged or totaled. If you can’t come up with the value of your car out-of-pocket you should probably keep this coverage.
2. Never buy extended warranties
Extended warranties are profit centers for retail stores. Think about the number of times you’ve been offered one of these “protection plans”. That’s how you know they are so important to retailers.
The average consumer benefit for extended warranties is about 10 cents on the dollar. That means out of all warranties sold, about 10 cents actually goes toward providing value to you as the consumer. The other 90 cents goes straight into the retailer’s pocket as increased profit. Why would you want to buy something you’ll get so little value out of?
Electronics is the number one area in which people buy extended warranties. The reasoning is you want to protect your expensive purchase. But the quality of today’s computers, TVs and other devices is much better than it used to be. As an example, the failure rate of flat screen TVs is about 3% in the first 3 years. Because the odds overwhelmingly favor the retailer and because today’s products are more reliable, extended warranties just don’t make sense. Ever.
3. If you can’t understand the purpose of the policy, you don’t need it
Just like investments, you should understand exactly what is covered under the policy before buying it. Some types of insurance, such as variable life insurance, is so complex that even lawyers sometimes have trouble understanding the contract language.
The more general the coverage the better. If a policy is so complex or riddled with exclusions that you have a hard time coming up with a case where you could make a claim, the policy isn’t for you.
4. Check the financial strength of the company
When buying insurance, most of us assume the company we’re buying from will be around indefinitely. But as we all know, businesses fail every day for tons of different reasons. Wouldn’t you like to know if the company you’re buying from will be around in five, ten or 20 years to service your claim?
There’s no way to know for sure. But thanks to A.M. Best, you do have access to information about the financial strength of your insurance company. Their rating system, ranging from A++ to F, gives you an idea of a company’s ability to pay claims for the foreseeable future. Stick with companies whose ratings are either A+ or A++. (Free registration is required to use the site.)
Particularly for life insurance and long term care insurance, which you may not need to draw on for decades, knowing the financial strength of the company before buying helps you make an informed decision and gives you peace of mind.
5. Some insurance is “use it and lose it”
Some insurance you buy, like health insurance, should be used as often as possible. Other types, though, should only be tapped in extreme circumstances. Two examples that fall under the latter are car and homeowner’s insurance.
Let’s look at homeowner’s insurance. Say your home is hit with hail and it causes $2,000 in damage to the roof. Should you file a claim? What if a tree falls on your house and causes $12,000 in damage? I’d argue no in the first case, and yes in the second.
Insurance companies love to collect your premiums and then be stingy when you make a claim. They’ll try to come up with reasons to deny your claim or pay you less than you deserve. Another dirty secret of the insurance industry is that if you make too many claims or even one major claim, the insurance company will fire you. Thus, use it and lose it.
You want insurance to be there for you when catastrophe strikes. For minor events, keep a well-stocked emergency fund.
6. Raise your deductible to save on premiums
This tip goes right along with the previous one. Not only will raising your deductible from $500 to $1,000 or even $2,500 save you money in premiums every month, you’ll also be less tempted to make small claims.
7. Evaluate needs regularly and shop rates
Your insurance needs will change throughout your lifetime. As you build wealth and assets you’ll need to step up your coverage. Get into the habit of going through your home once a year to document your stuff. Make a note of what you paid for each item, especially the big stuff. One way I’ve found to make this easy is to walk around our apartment with my smartphone, recording a video of each room and talking out what I paid for each item. This will make it easier if I ever have to file a claim.
If life has been good to you and you’ve amassed serious wealth, think about getting an umbrella policy. It sits on top of your other policies and protects you against lawsuits that could exceed the coverage of those other policies.
Knowing your needs lets you buy exactly the amount of coverage you need, and helps you avoid under- or over-insuring.
8. What coverage does your credit card provide?
You can avoid a lot of extra expense simply by knowing your credit card benefits. Here’s just a sampling of free benefits one of my cards offers: Extended warranties (for one additional year), rental car coverage, 90 day purchase protection from damage or theft, travel assistance and secure online account numbers. This is in addition to the cash back I get on every purchase.
The best way to find out which benefits your card offers is to check the cardmember agreement that came with your card. You could also log into your account and find it that way.
9. Self-insure via an emergency fund
Life throws you curve balls. Cars break down. Kids get sick and end up in the hospital. We get laid off. Before you do anything else, you need to have an emergency fund of $1,000. After you’ve paid off consumer debt, build that to three months of living expenses. Then six months. This money will protect you from unforeseen events that will happen. It’s much more efficient to self-insure with an emergency fund than to buy extra insurance.
10. Only insure things you can’t afford to lose
When you insure you protect. You protect yourself from loss. But not just any loss. If you tried to insure yourself against every conceivable loss you’d quickly run out of money. That’s why you need to be smart about which insurance you buy.
A good rule of thumb is you should only insure things you can’t afford to lose. This helps you avoid insuring against every possible event. Think back to the time you were in the furniture store, looking for that new couch. When you found the right one, your salesman probably tried to sell you the extended protection plan to protect the fabric from damage. But ask yourself – Would I suffer irreparable harm if the leather got scratched? No! It’s just a couch.
The same goes with most other things you’re sold an extended warranty on. Office chairs, digital cameras, smartphones, washing machines, laptops…I could go on and on. Just say no.
11. Think about who you’re insuring
Banks love it when you pay to insure them. I’ll give you two situations where this is the case.
When you get a mortgage, the bank asks if you want to add an obscure insurance known as mortgage life insurance. They claim that if you die you or your survivors won’t have to pay off the mortgage. That’s true, but the policy pays off the lender if you die, not your survivors. And it costs ten times what term life insurance costs.
In a related example, some sneaky credit card companies have been putting unemployment insurance or other coverage onto people’s bills each month. Again, these products protect the lender if you’re not able to make your payments. Make sure you go through your statement every month to make sure your bank isn’t ripping you off.
In either case, a simple level term life insurance policy is best because the proceeds go to your survivors who can decide how best to use the funds.
12. Don’t buy any policy that’s narrow in its benefit
Many types of insurance fall into this category. Just to name a few: Accidental death and dismemberment, stroke insurance and cancer insurance.
These policies are so narrow in their coverage that very few people in very few situations are likely to benefit from them. They are riddled with exclusions and are designed to take advantage of your fear of getting one of these conditions.
It’s best to buy general insurance, such as life insurance or disability insurance, that covers much more than these single-issue insurance policies.
For more information, see these posts: