When Insurance is Prudent

Insurance is only prudent when it yields the best risk financing returns and only when all other risk transfer alternatives are less viable.

Many buyers of insurance purchase insurance under the misguided notion that Insurance is the panacea to all their risk problems, real or imaginary and often wake up from a terrible nightmare that all they paid for all these years when there were no claims was just for “a peace of mind”.

Insurance should rather be viewed and assessed as a form of risk transfers through a financial instrument in the wider context of risk management and rather as just a straight forward purchase of an insurance policy for the peace of mind. The basis for buying or not buying insurance ought to solely be an economic decision, separated entirely from any other considerations like emotion of fear, if objectivity is key to the insurance purchase decision.

Going back to basics, what is Insurance and how does it work? Insurance is the pooling of resources of the insured with a common perceived risk threat into a common pool of funds so that in the event a claim by one or more at different times in a period of time, the needy member can be helped by the others. But Insurance will never work in a sustainable manner if every member claim against the fund at the same time or there are more claims to be paid out vis-a-vis the aggregate premiums collected for the period of time in question.

Having known that for Insurance to sustainably work in the long run, the outflow of payments and expenditure must be less than the inflow of premiums, we can now proceed to examine Insurance in the wider context of Risk Management.

Risk Management is the actual purpose in the purchase of insurance, for had it not been for risk management, one who never have bought any insurance except perhaps constrained by legal requirements as in the purchase of compulsory third party liability insurance when operating a motorized vehicle on public roads.

But insurance is not the only instruments available in transferring a risk; rather insurance is only one of the many ways within risk transfers techniques to transfer a risk via risk financing.

For example, one can transfer his risk by contract. The owner of a building under construction may transfer his risk as the owner of the land and building whilst under construction to the main contractor under contract with stipulations that the main contractor bears all risks associated with the construction activities 24/7 during the construction period until official hand-over. The owner, if he wish further can also stipulate that the main contractor finance his assumed risk with adequate insurance.

The main contractor can also pass on some of his risk to his subcontractors by way of contract and risks get transferred down the line.

Aside from transfers, risk can also be managed by avoidance and reduction.

If you view a certain risk to be too, you can decide not to indulge in that business venture or activity and avoid the risk and therefore avoid the exhorbitant insurance premium charged to insure that particular risk.

On the other hand, if you felt compelled that you must go ahead despite the risk, you can plan ahead carefully to avoid head on collisions with the assessed risks and strategies on how to mitigate the losses in the event of a loss.

For example, smoking is a known cause of lung cancer not only to the smoker but worse still to the people around him that are subject to his second hand smoke.

Risk Management strategies for the smoker would include quiting smoking (avoidance), or reduce smoking (reduction) or risk financing by buying a health insurance policy that does not exclude treatment for smoking relating diseases in the event he falls sick as a result of smoking.

It would be pretty obvious that quiting smoking would be the wisest and most economically viable choice and that does not even involve the buying of insurance.

But alas, the damage may already have been done due to the many years of past smoking, so even when one has quit smoking, one may want to retain the existing health insurance policy or purchase a hitherto uninsured risk, just in case one falls sick due to a smoking related disease that required expensive medical treatment.

Therefore, whilst insurance and insurance really ought not be the first choice, but rather the last and final option to any risk management alternatives, insurance is prudent really only as the final fall back, back-up financial plan.

So, before you rush out to buy anymore insurance or continue to blindly renew your existing insurance policies, ask yourself this simple question: what am I really insuring against and could this risk be possibly managed in other ways, other than being risk financed by an insurance transfer of risk, because financial risk transfers attracts premium and insurance premium is basically expenses.

Can these risks that I now insured against be avoided, reduced or transferred in other non insurance ways?

When and only when you come to the dead end where the risks in question could not be managed in any other satisfactory way than financial risk transfer through the purchase of insurance, than, insurance is essential and therefore prudent.

But more prudent is to insure exactly the risks you have identified and not be circumvented by some clever exclusion clauses and also to ensure that you insure with a reputable and bankable insurance company.

It is pointless hanging on to a worthless piece of contract paper when you need the compensation money most from the risks you have insured against, with the insurance company you thought you can rely on, and this is when insurance is prudent.

Is it still, today?