Tuesday, January 22, 2013

Cutting Off The Tail, Part 1

How To Ensure That You Are Protected If The Worst Happens


The US has backed away from the so-called “fiscal cliff,” equity markets have rebounded (with the S&P500 recently at levels last seen in 2007), volatility in the markets have declined, and junk credit spreads are going back down to foolhardy levels.  The US housing market appears to be rising again, and the European debt crisis seems to have died down to the level of an occasional whimper.  Not that there aren’t a few clouds on the horizon, but for now the environment appears to be reasonably calm and at least moderately positive.  Considering the events of the last several years, an oasis of calm is a good time to double check your preparations for calamity, financial and otherwise.  In this and the next couple of posts, I will lay out some common sense preparations everyone should make while things are relatively good so that you don’t have to worry about the worst case scenarios (as much) when the next period of instability inevitably comes about.  As an additional bonus, having ensured that the worst possible outcome shave been mitigated you will be free to take on more investment and/or professional risk if you choose to do so.  Fundamental to personal financial belt-and-suspenders preparation is sufficient insurance coverage. 

A basic principle of rational insurance buying is that you should only insure items or events that you cannot afford to weather yourself without undue financial risk.  So carrying collision coverage on a $2,000 beater car that you have had for a dozen years is a waste of most people’s money (as they can presumably replace the car out of pocket relatively easily), while forgoing homeowner’s insurance on a $400,000 house is likely to be a poor decision as well for the opposite reason (most people cannot afford to rebuild the house out of pocket with financial hardship).  The insurance premium may look cheap on some risks you should not insure, but rest assured: insurers are quite efficient at pricing risk and they will generally price your premium sufficient to cover the expected losses, plus their overhead costs, plus some profit.  As a result, if you are insuring risks you can afford to eat in the event of a loss, you are merely padding an insurer’s profits at your expense.
So what insurance should the risk-managing investor maintain?  There are three clear-cut forms of coverage every investor should maintain, and two others that may be appropriate depending upon one’s circumstances.   First and foremost, every investor should have adequate liability insurance, such as an “umbrella” or excess liability policy.  Unfortunately, every individual with non-trivial net worth is a potential target in a lawsuit and there are oh, so many ways to become the target of one.  Fortunately, umbrella policies with liability coverage limits of $1 million or more (in excess of any underlying coverage of your home or car) are readily available at relatively low cost (a few hundred dollars per year).  While a million dollar plus settlement is unlikely for any of us, having such coverage in place means you will not be financially devastated by such an outcome and that you will have the insurance company’s lawyers fighting tooth and nail to avoid having to pay an outsized claim.  I believe that such coverage is an absolute necessity and failing to carry such a policy is taking a foolhardy risk that can be inexpensively insured away.

The second necessary type of coverage is homeowners’ and auto insurance.  While there is an important element of property damage coverage (especially with homeowners’ coverage), both of these policies are needed for investors because they offer liability coverage and will generally be required by your insurer in order to qualify for an umbrella liability policy as discussed above.  Collision and comprehensive coverage for a vehicle may or may not be worth carrying depending on the value of the vehicle compared with your net worth and risk tolerance.  For example, an investor with a $100,000 net worth who owns a $20,000 car would probably wish to maintain property coverage on the vehicle because a total loss would equate to a loss of 20% of his or her net worth.  In contrast, an investor with a $2 million net worth owning the same car might rationally choose not to carry property coverage on the vehicle because a total loss would represent a 1% loss of net worth (equivalent to a sloppy day in the financial markets).  In contrast, maintaining sufficient homeowners’ property coverage (and possibly flood insurance if you are in a flood plain) is probably appropriate for everyone as most investors would not want to sustain a financial loss equal to the reconstruction costs of their home.
The third type of insurance every investor should maintain is some form of health insurance.  This may be provided by an employer or purchased on your own, but given the huge unpredictability of healthcare costs in the US it would be foolhardy to forgo healthcare insurance.  That said, if you have a choice on the details of your policy it probably would be wise to have a "high deductible" plan which offers substantially lower premiums in exchange for a deductible of as much as $10,000 annually.  One should only insure losses which you cannot relatively easily "eat" without significant financial repercussions.  If a $5,000 portfolio loss would not be material to your net worth, why should a $5,000 healthcare expense that is less than your deductible be different?

Finally, there are two kinds of insurance which may be important risk management tools for investors: disability income and life insurance.  In large part, the need for both of these forms of insurance hinge on the answer to the same question, namely if you are no longer earning an income (due to disability or death) would you and your family be in serious financial difficulty?  If the answer is yes, you should have both disability income and life insurance coverage.  Disability coverage may be offered through your employer or be bought in the open market.  Life insurance is usually best purchased away from an employer plan unless you have health risks that would make you difficult to insure as an individual.  For most people buying life insurance in the open market level term insurance with a rate fixed for 10 to 30 years is the best product to buy due to its simplicity, transparency and relatively low cost.  While there are a few situations where a permanent life policy (universal life, whole life, etc.) would be appropriate, the vast majority of life insurance buyers would be better served buying term life insurance.

While I have attempted to lay out the most important forms of insurance coverage, this list is by no means exhaustive.  If you feel the need for some sort of coverage and you cannot afford the losses this insurance would cover, by all means buy the coverage.  However, before you buy insurance make sure you understand what the policy covers (and does not over), look very carefully at any new product pitched to you, and revisit whether you really need to part with those premium dollars.

In the next two parts of this little series of "covering your assets" posts, I will address how to check up on your portfolio compared to your risk tolerance, and how to mitigate some of the non-financial risks we all face.

As always, the above is not intended as financial or investment advice.  Consult your advisors, do your own due diligence and be careful.  I am just some dud typing away on the interwebs so why would you take my advice?

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