Insurance basics: protecting what you cannot afford to lose

A sound financial plan has two sides: growing your money and protecting it. Insurance belongs to the second. You pay a smaller, predictable cost, the premium, to avoid a large and uncertain one. The aim is not to insure everything. It is to cover the losses that would seriously damage your finances.

Product names, rules and tax treatment differ by country, so use this as a framework and read the documents for any specific policy.

The core idea: insure what you cannot afford to lose

Ask two questions about any risk. How likely is it, and how bad would it be? Insurance is best suited to events that are unlikely but very costly: a major illness, the death of a main earner, a house fire, a serious accident. It is poor value for small, predictable expenses, which are usually cheaper to pay for directly.

A helpful rule is to self-insure small risks from savings and to buy insurance for the large ones.

The main types

• Health insurance. Medical costs can be very large and uncertain. Understand the premium, the deductible or excess you pay first, any co-payments, and the maximum you could pay out of pocket in a year.
• Life insurance. It pays money to your dependants if you die. It matters most when others rely on your income, such as a partner, children or parents. Term insurance covers a fixed period and is generally the simpler, lower-cost form. Permanent policies combine cover with a savings element and cost more, so many people compare them carefully with buying term cover and investing the difference.
• Disability or income protection. It replaces part of your income if illness or injury stops you working. For many working-age people, the risk of long-term disability is higher than people expect, and this cover is often overlooked.
• Home and contents insurance. It covers damage to or loss of your property and often liability. Lenders usually require buildings cover on a mortgaged home.
• Vehicle insurance. Often a legal requirement, covering damage and liability to others.
• Liability cover. Some policies protect you against claims from others. Larger-value liability cover can be worth considering if you have significant assets.

How much life cover

There is no single answer. A common rule of thumb is to multiply annual income by ten or more, but a better approach is to add up what your dependants would need: outstanding debts such as the mortgage, a number of years of living costs, future education costs, and funeral costs, then subtract savings and any existing cover. Review the figure when your circumstances change.

What to compare

The cheapest premium is not always the best policy. When comparing, look at:

• What exactly is covered, and what is excluded.
• The maximum payout and any sub-limits.
• The excess or deductible, which is what you pay before the insurer does.
• Waiting periods and the conditions for a claim.
• The insurer's reputation for paying claims and handling them fairly.
• Whether the premium is fixed or can rise, and how.

Read the exclusions in particular. They tell you what the policy will not do.

Cases where insurance is usually not worth it

• Extended warranties on low-cost items, where the cost can exceed the likely repair.
• Duplicate cover that you already have through another policy or your employer.
• Cover for risks that would not seriously harm your finances.

Keep cover current

Review your insurance when something changes: a new home, a child, a marriage or separation, a new job, a business started, or a large new purchase. Cover that was right five years ago may now be too little or too much.

Common mistakes

• Buying on price alone without reading the exclusions.
• Being underinsured on the big risks while overinsured on small ones.
• Letting a policy lapse after missing a payment.
• Not telling the insurer about relevant changes, which can affect a claim.
• Mixing insurance with investing without understanding the costs.

A short checklist

• I have health cover appropriate to my situation.
• If others depend on me, I have enough life and income protection.
• My home and belongings are covered for their real value.
• I know my excesses or deductibles and can afford them.
• I review my policies once a year or when life changes.

Insurance does not make you richer, but it prevents a single bad event from undoing years of saving. That makes it a foundation for every other money decision.