When Insurance is Prudent

One of the main principles of financial management is prudence. The concept of prudence- in this context- refers to having a long term view and displaying sufficient financial acumen. As a risk-management tool, the concept of insurance is premised on financial prudence- protecting your assets, life and health.

Risk management- which is based on prudence- offers a few options. When you are faced with a risk, you can avoid, control, transfer or accept that risk. Once you can avoid, control or accept a risk, insurance may not be necessary or prudent.

If you can only control an insurable risk to a limited extent or cannot bear the potential losses, then it will be prudent to transfer the risk to an insurer. How you perceive a risk is often dependent on your risk tolerance (subjective) and your financial circumstances (objective). Prudence is a function of your judgement in some cases.

Naturally, some forms of insurance may be more ‘prudent’ than others in certain circumstances. Indeed, there’s more to acquiring insurance for a risk than simply having that risk. Risks can vary by severity. For this reason, travel insurance and medical coverage for minor medical expenses are hardly ever considered prudent.

There are also different types of insurance that are designed to protect what you value most. When insurance is prudent also depends on what you’re protecting.

Life insurance: For certain, your life is valuable. However, that hardly suggests that a million dollars of coverage on a life insurance plan is prudent for you. Life insurance is most relevant when you need it for family protection, business, mortgage protection, estate planning or as part of a complete financial plan. If you want ‘returns’ from it, or match it according to replacement income instead of expenses, it often becomes superfluous.

Auto/ Vehicle insurance: Auto insurance is mandatory for the third-party coverage it offers. However, not every aspect of auto insurance is prudent. For example, fully comprehensive coverage on a second-hand vehicle may be unwise in a few cases. Reducing the potential size of ‘excess insurance’ is also prudent when you can bear the potential loss comfortably and can save money through lower premiums.

Health insurance: This type of insurance is usually prudent once you’re alive. Naturally, all health plans are not the same. It is not shrewd to have medical coverage for routine medical expenses. This only increases your premium, since an additional burden is placed on the insurer. However, health insurance is the most vital form of optional insurance to have.

Home & property: Buildings are usually capital-intensive investments that would result in substantial financial losses through damage and destruction. It is also important to have coverage for properties because it can extend to third parties. The capital-intensive nature of these assets make it wise to have sufficient home or property insurance.

Insurance is always a balance between the value of the protection and the premium. If the premium is too high in relation to the coverage, it indicates that the risk is deemed too large for an insurer to undertake at a level that is affordable to the insured.

Life involves uncertainty. One can do certain things to reduce risks, if not eliminate them. Insurance is prudent when it is used as a risk-transfer mechanism. In other words, it is prudent when a substantial, insurable risk cannot be avoided or accepted. Therefore, it is sometimes wise to take advantage of insurance beyond the fact that it is necessary.