5.2 - Managing Personal Risk
Types of Insurable Risks Individuals Face
People face all kinds of financial and physical risks, like a costly car accident or an illness that keeps them from working. An insurable risk is one that involves potential loss due to chance, like an accident or weather event, and it has to be quantifiable and statistically predictable enough for an insurer to estimate the likely cost and probability of the loss.
Insurance works by pooling risk. Many people each pay a fairly small premium into a pool, and the few who actually suffer a loss in a given year get paid from it. Insurers use data on large groups (like how often drivers of a certain age crash) to predict roughly how many losses will happen and set premiums high enough to cover them. That's why a risk has to be measurable to be insurable. Some risks can't be insured: losses that are certain (normal wear and tear on a car), losses someone causes on purpose, and risks where you could also come out ahead, like the chance that a stock you own drops in value.
There are three main types of insurable risk. Personal risk relates to the health and well-being of the person insured, like injury or illness. Property risk relates to loss or damage to property, like a damaged home, car, or belongings. Liability risk relates to harm caused to other people or their property, like damaging someone else's parked car or injuring a pedestrian through reckless driving.
Each type of risk lines up with certain kinds of insurance. Personal risk is covered by health insurance, life insurance, and disability insurance (which replaces part of your income if illness or injury keeps you from working). Property risk is covered by homeowner's and renter's insurance and by the collision and comprehensive parts of auto insurance. Liability risk is covered by the liability parts of auto, homeowner's, and renter's insurance.
Types of Insurance Individuals Use
People buy various kinds of insurance to protect against these losses: health insurance, auto insurance, homeowner's insurance, renter's insurance, and life insurance.
Insurance buyers pay a premium, whether annually, semi-annually, or monthly, and in return they get a policy with a specific coverage amount. If a covered loss happens, they can file a claim for reimbursement, subject to policy limits, deductibles, and terms.
A few terms show up in every policy. The premium is the price of the insurance. The policy is the contract that spells out what's covered. The coverage limit is the most the insurer will pay for a covered loss. The deductible is the amount the policyholder pays out of pocket before the insurer pays anything. A claim is the request for payment after a loss. For example, if a covered car repair costs $3,000 and the deductible is $500, the driver pays $500 and the insurer pays $2,500.
Health insurance reimburses for medically necessary care and sometimes preventive care too, and it's often provided as an employee benefit, with the employer covering some or all of the premium.
Health plans usually share costs with the patient in a few ways. After the deductible is met, the plan may charge a copay (a flat fee, like $25 for a doctor visit) or coinsurance (a percentage of the bill, like 20%). For example, with a $2,000 deductible and 20% coinsurance, a $10,000 hospital bill costs the patient $2,000 plus 20% of the remaining $8,000, or $3,600 in total, and the plan pays $6,400. An out-of-pocket maximum caps how much the patient pays in a year. In the U.S., most plans must cover certain preventive care, like vaccines and many screenings, at no extra cost. When an employer offers health insurance, the worker's share of the premium often comes out of each paycheck as a pretax voluntary deduction (5.1).
Auto, homeowner's, and renter's insurance let policyholders file claims for financial losses to their own property, like car or home damage or stolen items, as well as for legal liability costs if they cause damage or injury to someone else.
An auto policy is really several coverages in one. Liability coverage pays for injuries and damage you cause to others. Collision coverage pays to fix your own car after a crash. Comprehensive coverage pays for damage from things other than a crash, like theft, hail, or hitting a deer. Homeowner's insurance covers the house itself, your belongings, and liability (like a guest getting hurt on your property). Renter's insurance covers your belongings and liability but not the building, which the landlord insures. Standard homeowner's and renter's policies usually don't cover flood damage, so people in flood-prone areas buy separate flood insurance.
Life insurance pays out to designated beneficiaries when the insured person dies, often used to replace lost income, cover end-of-life expenses, or fund a family's future needs like housing or education.
There are two main kinds. Term life insurance covers a set period, like 20 or 30 years, and pays only if the insured person dies during that time. It's much cheaper and is usually enough for someone who wants to protect a family while the kids are growing up or a mortgage is being paid off. Whole life (or permanent) insurance lasts for the person's whole life and builds a cash value that can be borrowed against, but it costs much more for the same payout.
Extended warranties or service contracts on expensive items like cars, appliances, or electronics work similarly to insurance, covering repair or replacement costs if the item breaks within a certain window.
Before buying one, it helps to check what the manufacturer's warranty already covers and to compare the price of the contract with the likely repair cost. For cheaper items, many people choose to cover a repair from savings instead.
Choosing Insurance Based on Risk Tolerance and Needs
How much and what type of insurance someone needs depends on legal requirements, personal risk tolerance, and how many dependents they have.
Some insurance is legally required, and requirements vary by state or country. In most U.S. states, auto liability insurance is required, and lenders providing home mortgages require homeowners to carry property insurance.
Lenders require insurance because the home is collateral for the loan (3.2). If the house burned down uninsured, the lender's security would be gone. For the same reason, car lenders usually require borrowers to carry collision and comprehensive coverage until the loan is paid off. State auto laws set a minimum amount of liability coverage, but many drivers buy more, since a serious accident can easily cost more than the minimum.
Beyond legal requirements, individuals decide how much coverage to buy and how much risk to take on themselves, often through deductibles. People with low risk tolerance tend to prefer more comprehensive coverage and are willing to pay higher premiums to avoid a big surprise cost later. People with higher risk tolerance might choose less coverage or higher deductibles, accepting the possibility of bigger out-of-pocket costs if something goes wrong.
There are four basic ways to handle a risk: avoid it (don't do the risky activity), reduce it (like installing smoke detectors), keep it yourself (pay small losses from an emergency fund, sometimes called self-insuring), or transfer it to an insurance company by buying a policy. Most people keep small, affordable risks and transfer the big ones they couldn't afford to pay for themselves.
The deductible choice shows this trade-off. Say Plan A has a $500 deductible and a $1,400 yearly premium, and Plan B has a $1,000 deductible and a $1,100 yearly premium. In a year with no claims, Plan B saves $300. In a year with one claim, Plan A costs $1,400 + $500 = $1,900 and Plan B costs $1,100 + $1,000 = $2,100, so Plan B comes out $200 behind. Someone with a solid emergency fund and higher risk tolerance might pick Plan B. Someone who couldn't handle a surprise $1,000 bill should pick Plan A.
People with dependents, like children or a spouse relying on their income, often need more coverage overall, like family health insurance, coverage on multiple vehicles, or more life insurance to provide for their family's future.
On the other hand, a single person with no dependents may need little or no life insurance, since no one relies on their income.
People can also lower their premiums by reducing risky behavior, like maintaining a clean driving record for auto insurance or not smoking and staying healthy for life insurance.
Insurers also set premiums based on other traits that predict risk, like age, where someone lives, the type of car, and, in many states, credit history. Common discounts reward lower-risk choices, like good grades for teen drivers, safety features on a car, or security systems and smoke detectors in a home.
It's also worth knowing that insurance fraud is a crime, whether it's an individual misrepresenting facts or filing a falsified claim, or an insurer or agent misrepresenting a policy or its benefits.
Examples of insurance fraud by individuals include exaggerating the value of a loss, claiming items that were never stolen, staging an accident, or lying on an application (like saying you don't smoke to get a cheaper life insurance premium). Examples by sellers include selling fake policies or lying about what a policy covers. Fraud can lead to denied claims, canceled policies, fines, and jail time, and it raises premiums for everyone else, since insurers pass those costs on.
Protecting Yourself from Financial Fraud
Beyond physical risks, households face risks from people trying to take their money. Predatory lending is when lenders use deception or aggressive sales tactics to push borrowers into loans with unfair terms. Warning signs include hidden fees, a much higher interest rate than the borrower qualifies for, pressure to sign right away, and loans that are clearly bigger than the borrower can repay. Payday loans are a common example, since their fees can work out to an APR of nearly 400% (see the calculation in 3.2).
Fraud is when someone uses deception to steal money or information. Phishing uses fake emails, texts, or phone calls that look like they come from a bank, a business, or a government agency. The message usually creates urgency ("your account will be locked") and asks you to click a link, "verify" your account, or share a password or one-time code.
Identity theft (defined in 2.1) is when someone uses your personal information to open accounts, borrow, or buy things in your name. Signs include accounts you don't recognize on your credit report, bills for things you didn't buy, and calls from debt collectors about debts that aren't yours.
Online scams include fake online stores, job offers that ask you to pay upfront, prize notices that require a fee to collect, romance scams, and investment schemes that promise guaranteed high returns. Scammers often ask to be paid with gift cards, wire transfers, cryptocurrency, or payment apps because that money is hard to trace or get back.
To avoid predatory lending, compare loan offers from several sources (banks, credit unions, and online lenders), looking at the APR, fees, and total cost, not just the monthly payment. Take time to read the terms instead of giving in to pressure to sign on the spot, since a legitimate lender will let you think it over. Before signing, it can help to talk to a nonprofit credit counselor, who can review the loan and suggest alternatives at little or no cost.
To protect against fraud, check whether an offer is credible before acting. Look up the company or agency yourself and contact it through its official website or phone number instead of using links or numbers in the message, and treat "guaranteed" high returns or prizes you have to pay for as red flags. Don't share personal or financial information with anyone who contacts you out of the blue online or by phone.
A credit freeze, which is free in the U.S. at each of the three credit bureaus (Equifax, Experian, and TransUnion), blocks new lenders from pulling your credit report, so a thief can't open new accounts in your name. It doesn't hurt your credit score, and you can lift it temporarily when you apply for credit yourself. If you do get scammed, act fast: contact your bank, report it (in the U.S., at IdentityTheft.gov or ReportFraud.ftc.gov), and seek legal aid, meaning free or low-cost legal help, if you need help getting money back or clearing your name.