Insurance Overview, Part II: A 30,000 Foot Perspective

Last week I posted an article about the theory of risk transfer.  It explores the fundamental ways risk is handled and when to employ various strategies.  In certain circumstances, it’s okay to retain risk.  In other circumstances, you should avoid or reduce risk.  This week, however, I’d like to take a high-level look at the tools available to you when transferring or sharing risk.

risk-hierarchy

This hierarchy maps out the landscape for handling risk.  Once the risk is identified and we move to the second tier, we have two options.  Speculative risk is when there is the possibility of loss or gain and is uninsurable.  Pure risk is when only the possibility of loss is present.  Depending on what type of loss will determine if it’s insurable or not.  Last week, I used the example of riding a motorcycle.  There are two types of risk in that example, physical injury and financial loss.  Physical injury can’t be transferred away, therefore it’s uninsurable.  Financial risk can be transferred and is insurable.

The fourth tier contains only insurable risks and is broken down into three categories; personal, property, and liability.  Personal insurance protects us from loss related to death, injury, illness, old age and unemployment.  Property insurance protects us from damage or loss of our property.  Liability insurance protects us from legal liability of physically injuring a person or damaging their property.  Let’s look at some examples of each of these.

Personal

Personal insurance protects against loss of income and health expenses.  Because physicians have such a great investment in obtaining the necessary skills to practice medicine, protecting against loss of income is particularly important.  Residents are the most exposed because they often have large amounts of student debt, yet still don’t earn enough to tackle it.

Term insurance is the obvious remedy.  This type of policy is the most straightforward.  You pay a premium for a specified amount of coverage in case you die.  It’s temporary, so If you die under coverage, the benefit is paid.  If not, then your premium is consumed and there is no benefit.  But how much is necessary?  That varies greatly on if the resident (or young attending) physician has a family to provide for, do they have a mortgage, or if their debt is federal or private.  There are two approaches to measuring one’s need for coverage.  The first, “human life value” approach estimates future earnings over your lifetime and is adjusted for inflation and taxes to the get a single present value.  The second, “capital needs analysis” estimates future expenses over your lifetime and is also adjusted to present value.  I personally prefer the latter because it’s focuses on your specific needs to assure they are met.  The human life value approach is more straightforward, but one’s income doesn’t always reflect their needs.  Obtaining coverage at a young age is key because the likelihood of early death is very low, so premiums are low as well.

Other forms of life insurance include “cash value” policies where a savings component is combined with insurance.  Portions of your premiums go towards the insurance component known as mortality costs and the remainder is contributed to building cash value.  There are various types of cash value policies including whole life, universal life, variable life, and hybrid policies that combine features of each.  These policies can range from pretty basic to extremely complex.  Anytime a complex decision is presented, many differing opinions emerge.  Cash value insurance is vilified by some (usually about fees) and praised by others (about removing the possibility of loss).  As for my own opinion, I believe that these policies are largely unnecessary.  However, they can be appropriate for the most risk averse savers who understand they’re paying a premium for the insurance component.  To go any further would be going down a rabbit hole that this article isn’t meant to cover, so I’ll have to save it for future posts.

What happens when you need to replace income due to disability?  Term insurance only pays a benefit if you die and cash value policies take decades to accumulate significant assets.  Again, for physicians, this goes back to protecting your investment in obtaining skills in medicine.  These skills earn you a high income, so it would be disastrous if you were to become unable to utilize them.  There are multiple sources of coverage including Social Security Disability Insurance, Workers Compensation, employer provided insurance, and self insurance.  Each of these are provided by differing levels of governance as shown below.

disability

SSDI and Workers’ Compensation are both very restrictive and the benefits are limited.  They will provide you with some income in limited circumstances, but don’t come near replacing a physician’s income.  The next step would be to check out what kind of coverage your employer provides, if any.  You should look to see if short term (<= 6 months) and long term (> 6 months) coverage is in place and what percentage of income is replaced.  After reviewing coverage through your employer, determine if there is still a gap between coverage and your needs.  If a gap still exists, then finding an individual policy is your last option.

The other type of protection under the personal insurance category is covering health care costs.  From here, there are two divisions.  First, health care expense insurance.  The need for this type of insurance is pretty universal.  In fact, it’s required.  Usually your employer will provide coverage for you and your dependents, or if you’re 65 and older you will likely qualify for coverage under Medicare.  However, if your employer doesn’t provide coverage or if you’re self employed you will be responsible to get individual coverage through state or federal insurance exchanges.

The second type of health care cost insurance is long-term care (LTC).  This type of insurance covers expenses related to stays in nursing homes, assisted living, home care, and other similar care.  A Boston College study showed that men and women age 65 have a 44% and 58% chance, respectively, of needing nursing home care at some point in their lives¹.  The study also puts an average stay at 10 months for men and 16 months for women.  The median cost for a private room is $92,378 annually².  Usually the decision to buy LTC insurance falls on the middle class because the poor can’t afford insurance and Medicaid pays for their care and the wealthy can self insure.  Primary LTC insurance works similar to term insurance in that there is no cash value.  Other forms of hybrid insurance also exist that combine annuities with an LTC coverage rider.

Property and Liability

Property insurance not only protects your own property (Direct) but also protects you from liability (Indirect).  There are two types of property insurance, homeowner and auto.  The main elements on a homeowner policy are coverage: 1) on the dwelling, 2) for personal property, 3) loss of use, and 4) medical payments for bodily injury or property damage caused to other people or property.  Auto coverage works similarly in that is also protects your own property and medical expenses and the personal liability of damage to others.  Determining if you are adequately covered by either of these policies and their subsections requires a line by line approach.  The typical physician doesn’t have any needs that stand out when it comes to these types of coverage and should rely more on their own personal risk tolerances when going over each type.

Where physicians do have a unique need is whether or not to purchase umbrella liability insurance.  This is coverage that works like an extension to existing homeowner’s and auto policies.  Because physicians are high earners, they are likely targets in our litigious society.  Liability coverage already exists from your homeowner’s and auto policies, but what happens when that coverage isn’t enough?  If found legally liable to an extent beyond existing coverage, you are required to pay the excess from your personal assets.  This is why you get just enough coverage under your homeowner’s and auto policies to qualify for umbrella insurance and use that as your “worst case scenario” protection.

The tricky part about insurance is that the proper amount of coverage often isn’t a black and white decision.  You need to periodically take the time to evaluate what the potential risk exposures are.  Then you need to use the theory of risk transfer to decide if and how much of those risks to avoid, retain, reduce, share, or transfer.  It’s quite possibly the most boring and tedious of financial agendas, but knowing you’re prepared for whatever life throws at you can bring immeasurable peace of mind.

So what do you think?  What types of insurance do you think are necessary or not?

References:

Wall Street Journal: “Long-Term-Care Insurance: Is It Worth It?”
AARP: Understanding Long-Term Care Insurance