What Does Insurance Do?Don Shaughnessy
An interesting question and if you ask 50 people, I doubt you will get 50 coherent answers. Maybe not 20. People often own insurance because they think they are supposed to, or because their spouse thinks they are supposed to, or because the government requires it, (car insurance) or because the bank requires it (fire insurance.)
While these may be true, and the motivator, for many, it is possible to rationally decide to buy insurance because it has value to you.
People usually think about insurance in two ways:
- Insurance protects wealth that exists. The fire insurance, the lawsuit for negligent driving, the all-peril loss of your 40 carat diamond, your errors and omissions coverage. or,
- Insurance creates wealth where none exists. Typically life insurance although some make the case for critical illness or disability income insurance.
While these are a little true they are very limiting.
First of all, 2) is almost always not the case. Life and other like forms of insurance protect an intangible asset. Your career value, the ability to earn income. Just because you cannot sell it to someone else does not alter its nature as wealth. Later on, these forms of insurance protect the wealth you have from being used to pay debts or taxes or medical bills.
So most simply, insurance protects wealth from loss. More true, but still not the complete reason that people should own insurance. Besides most people will not buy the proper insurance for that reason. It has no feelings attached.
With life insurance, there is nothing in it for them. It is like betting against the home team. There is a loss no matter the outcome. If the home team wins, (live a long time) then I lose the premiums. If I collect the benefit, I died.
Most people do not own life insurance for what it is. Actually that would be an odd reason to own anything. Value is in use.
Salespeople usually suggest that people own it for what it does. Create liquidity, protect assets from forced sale, liquidate actual and implied liabilities and in some cases a way to accumulate wealth. Again limiting although possible to explain.
People should not own insurance only for what it is, that is just silly, or only for what it does, that is just the adult decision. People should own insurance because it allows them to do things they can do only if they have it. It offers them choices previously unavailable.
For example, suppose I owe the government $2 million upon my death. I could own some assets specifically for this liability. Those assets have limits, principally they must be liquid and secure. That is a very restrictive start. They cannot be business assets because those are neither liquid nor secure. They cannot be things like development properties or personal real estate. Again not predictable enough. The limitations dominate.
Suppose instead, I set aside $1million in a secure and somewhat liquid account to pay premiums on a $2 million life insurance policy. Maybe even buy an annuity. Now my tax liability is liquidated, whenever I may die, and I have $1 million in my hand to do with as I please. Maybe educate grandchildren, or payoff mortgages, or make down-payments, or buy a nice Hennessey Venom GT Spyder like Steven Tyler’s, or invest in a very speculative, completely illiquid investment, like a farm 5 miles out of town. Maybe some seed money for the kid’s business or a nice condo in the Caribbean.
No matter my tastes, the insurance allows me to do something I could not have done without it.
With insurance done right and for the right reasons, the home team always wins.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. firstname.lastname@example.org