Help people decide how to handle risk.
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Should I buy a certain type of insurance?
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Measure the full exposure of potential economic loss event.
(What is the Present Value of the economic loss sustained?)
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Decide on an amount that is an "affordable" loss based on a pre-decided level of loss you are willing to retain (50% of cash cushion, Credit Card limit, 1 month of income).
Is this loss "unaffordable," according to this pre-decided benchmark?
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YES
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Does this event have a low frequency/likelihood of occurrence?
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YES
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Retain or Avoid Risk
If it's probably not going to happen, and if it does it won't affect you much, retain the risk, or avoid if desired.
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NO
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NO
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Does this event have a low frequency/likelihood of occurrence?
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Reduce or Avoid Risk
It has a decent chance of occurring, but won't be devastating, so just try to keep it from happening.
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YES
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NO
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Transfer (Buy Insurance)
It probably won't happen, but if it does, it will generate a large loss. Pay an insurance company to take that financial risk from you.
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Avoid.
If something is really bad and really likely, avoid it at all costs.
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"But I don't need said insurance."
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"But I can't afford all that insurance."
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Raise level of risk willing to retain, and go back through decision tree.
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"But I can't get insurance for this loss."
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YES
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Nobody said anything about "Need." Insurance is a financial risk management tool based on exposure and probability. Need is irrelevant. I "need" food. I don't buy food insurance. If my food spoils sooner than I expected, I go back and buy more.
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Not being able to "afford" a loss is why we buy insurance in the first place (see above). We take an ounce of pain to prevent the unaffordable effect of a 10 lb hit.
It is logically inconsistent to call insurance "unaffordable." If it feels that way, the loss actually occurring will likely have devastating effects far beyond the insurance premium.
However, if cash-flow is tight, risk priorities can be shifted slightly.
Is cash-flow tight?
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NO
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You can't afford not to have this form of insurance.
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This is truly unfortunate. Modify other aspects of your financial plan to account for the potential loss, avoid the loss, or try to contain the loss and create a contingency plan.
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Insurance
