Right-Sizing Your Insurance Coverage

Most households are insured in the wrong places. They pay every month to protect against small, survivable losses, such as a cracked windshield or a minor fender bender, and carry too little against the rare event that could take years of savings: a lawsuit, a death, a disability, a house that costs more to rebuild than anyone checked. This chapter shows how to move money from the first kind of cover to the second, so the same budget buys more real protection.

Insure what would break you, carry what would not

Insurance is a trade. You pay a certain small amount (the premium) so that an insurer takes an uncertain large one. Because insurers must cover their claims, their costs and a profit, the average policyholder gets back less than they pay in. That is fine when the loss you are transferring is one you could not survive. It is a poor trade when the loss is one you could pay from savings without much pain.

So the useful question for every policy is not "how likely is this?" but "how bad would it be?" Rank risks by severity:

• Catastrophic: losses that would take years to recover from, or never. Liability after an accident you caused, losing your income to death or disability, a destroyed home, a major illness. These deserve full cover with high limits.
• Painful but survivable: a few thousand dollars of repairs or bills. These are where higher deductibles belong.
• Annoying: a broken phone, a lost suitcase, a small rental car scrape. These are usually better paid from your own pocket.

Volume 1 on this shelf explains each type of policy. This chapter is about calibration: the limits, deductibles and add-ons inside the policies you already have.

Deductibles: let your reserve carry the small losses

A deductible is the part of a claim you pay before the insurer pays anything. Raising it lowers the premium, because the insurer no longer handles the small claims that are expensive to process. The real limit on how high a deductible you can carry is cash: if a claim happened tomorrow, could you pay the deductible without borrowing?

This household's cash covers 3.0 months of essentials. Its full 6-month target would be $24,000. A reserve like this can absorb a higher deductible on car and home policies, as long as the deductibles on all policies together stay well below what is in the account, since two claims can land in the same year (a storm can damage the house and the car at once).

What does the higher deductible buy? The premium saving is yours every year, and if you put it aside it becomes part of the reserve that pays the deductible.

Saving $40 a month in premiums and keeping it in a savings account earning 4.0% builds $2,647 in 5 years. The test is simple: get a quote at both deductibles, then compare the yearly saving with the extra amount you would pay on a claim. If the saving would cover the gap within a few claim-free years, and you have the cash today, the higher deductible usually comes out ahead. If you file claims often, or have no reserve yet, a lower deductible may be the better fit for now.

Liability limits and the umbrella

Liability coverage pays when you injure someone or damage their property and are found responsible. It is the line most often set too low, because the minimum your state requires for car insurance is far below what a serious injury claim can cost, and a judgment above your limits can reach your savings and, in many states, part of your future wages.

Three steps keep this coherent:

1. Raise the underlying limits. Car and home policies carry their own liability limits. Raising them is usually inexpensive compared with the risk covered.
2. Add an umbrella policy. An umbrella sits on top of your car and home liability and pays after they are exhausted. Insurers require minimum underlying limits before they will sell one, so step 1 comes first. Umbrella cover is sold in large round steps and is cheap per dollar of cover, because claims that reach it are rare.
3. Match the policies. Make sure every driver, car, home and rental property you own is listed on the umbrella, and that uninsured and underinsured motorist coverage on your car policy is set at the same level as your liability limit. That coverage protects you when the other driver has too little insurance, which is common.

How much umbrella? A frequent rule of thumb is at least your net worth, and more if your future income is high, you have teenage drivers, a pool, a dog with a bite history, a rental property or a public profile. There is no precise formula. The first step of umbrella cover is usually priced low enough that most households with assets to protect find it worth a quote.

Life and disability: size cover to the income at risk

Life insurance is for people whose death would leave someone else short of money: a partner, children, a co-signer. The amount should replace the income they would lose for as long as they would need it, plus any debts or goals you want paid off at once.

One clear way to think about it is the lump sum that could pay a year of lost income.

To replace $50,000 a year indefinitely, at a 4.0% withdrawal rate, takes $1,250,000. But a family rarely needs income forever. If the need ends when the youngest child is grown, a smaller sum can be spent down over that period.

With a 5.0% return and 3.0% inflation, a payout of $850,000 pays $49,980 in the first year, rises with prices, and lasts the full 20 years. The highest steady rate that lasts that long is 6.0%, which is why a 20-year need costs about $833,333 rather than $1,250,000. Subtract savings the family could use and any survivor benefits, and add debts you want cleared. The life insurance needs calculator does this with your figures, and the term vs whole life calculator compares the two main policy types. For most income-replacement needs, term insurance buys the most cover per dollar.

Disability is the risk people underinsure most. Your ability to earn is usually your largest asset, and a long illness or injury is more likely during a working life than death. Check what your employer's group policy pays, for how long, and whether its benefit is taxable (it usually is if your employer paid the premium). The disability insurance calculator shows the gap between that benefit and your spending.

Your home: rebuild cost, not market value

The dwelling limit on a homeowners policy should equal what it would cost to rebuild the house, not what it would sell for. The two can be far apart: market value includes the land, which does not burn, while rebuild cost depends on local building costs, which can jump after a regional disaster when every contractor is busy.

Check four things on the policy:

• Replacement cost, not actual cash value. Actual cash value pays what the damaged item was worth after depreciation; replacement cost pays what it costs to replace it new. The difference on a roof or a kitchen is large.
• Extended replacement cost. An endorsement that pays a set percentage above the dwelling limit if rebuilding costs more than expected.
• Ordinance or law coverage. Older homes must be rebuilt to current building codes, and the standard policy may not pay for the upgrade.
• Exclusions. Standard policies exclude flood and earthquake. Chapter 8 covers both.

Renters need cover too: a renters policy is inexpensive and includes liability, which often matters more than the belongings.

What to trim

Some cover duplicates protection you already have or insures small losses at a high price. Common candidates to review:

• Collision and comprehensive on an old car. When the car's value is low enough that you could replace it from savings, dropping these can make sense. Keep liability.
• Rental car damage cover at the counter. Your own car policy or the credit card you pay with may already cover it. Check before you travel.
• Credit life and payment protection insurance sold with a loan or card, which usually costs more per dollar of cover than term life.
• Accidental death policies, which pay only for one cause of death; term life covers all of them.
• Extended warranties on electronics and appliances, which insure small, survivable losses.

Review the whole set once a year and whenever life changes: a marriage, a birth, a home purchase, a large raise, a teenage driver. Shopping your car and home policies every two or three years keeps the price honest.