Insurance 101

Insurance is one of the less interesting financial topics but it is an important part of sound planning.  Insurance protects us from financial ruin in the event of uncommon but devastating disasters like fire, flood, disability and even death.  People buy insurance often because they lack the money on an individual basis to cover the effects of a particular disaster.  How many of us, for example, have cash available to pay our current mortgage and completely rebuild our home if it was destroyed by fire?

Insurance is all around us.  Most states require drivers to have auto insurance.  As we have been reminded time and again in the recent political debate, approximately 85% of Americans currently have health insurance.  If you own a home, you were probably required to purchase title insurance and home insurance (and maybe mortgage, flood or hurricane insurance).  You might have life insurance.   Insurance is crucial for the business world too.  As just a few examples, banks are supported by deposit insurance, doctors and lawyers by malpractice insurance and farmers by crop insurance.

Insurance works by having a large number of individuals or businesses (“insureds”) contributing a share of money representing their individual risk of disaster (a “premium”) to a common insurance fund.  Ideally, only a small percentage of the insureds actually experience disaster and require a payout from the fund and each year, the insurance fund should take in more in premiums than it pays out.  The surplus funds are invested to generate more money to protect the fund in the future (and, of course, to turn a profit for the insurance company).

Occasionally, there are too many disasters, too many claims on the fund and not enough funds to go around.  We see this more often than we would like in situations like the 9-11 terrorist attacks, Hurricane Katrina and particularly now with regard to mortgage insurance.  Professor Niall Ferguson’s Ascent of Money provides a detailed and interesting history of the insurance industry.

When you are in the market for insurance, the Internet can be a great place to start your search.  If you type a general keyword like “life insurance” or “home insurance” into your favorite search engine, you will come up with a variety of service providers.  There are services like reliaquote.com or esurance.com that allow you to type in your insurance needs and have brokers from numerous agencies contact you to solicit your business.

One lesson I had to learn the hard way, however, was that sometimes it is less expensive to forgo the insurer referral websites and just contact a major insurer directly.  For example, you might call Traveler’s, Aetna, or MetLife or put your information into their respective websites.    Once you put your name into an insurance referral site, the insurer has to pay a referral fee to the broker which is then passed on to you.  Even if you then call the insurer directly to sign up for their policy, they might indicate they cannot help you because a broker already “owns” your business.  The referral fees can be significant depending on the type of policy you are buying. Fortunately, the referral fees are typically a one-time upfront charge so you don’t get punished year after year on a multi-year policy if you have to pay them.

When you purchase insurance, there are three primary things to look for:

1. Premium Amount. This is probably the area we focus on the most as insurance consumers.  The premium is the amount we regularly pay for the insurance (monthly, quarterly or annually).  While this is certainly a huge factor in our decision-making process, it shouldn’t be the sole one.
2. The Financial Strength of the Insurer. It doesn’t do much good to be dutifully paying your premiums if the insurance fund is weak and can’t pay out claims in the event of a disaster.  How do you find out what the financial strength of the insurer is?  There are several ratings agencies that assign financial scores to insurers.  The most frequently cited rating agencies are A.M. Best, Fitch, Moody’s and Standard and Poors.  Each rating agency assigns its own rating scale.  Below is a compiled summary.
3. The Coverage Amounts Included in the Premium.  Different types of insurance have different coverage categories.  Automobile insurers for example, typically quote using 3 numbers–per person, per accident and property damage.  If someone refers to a 100/300/50 policy, for example, the insurer is proposing coverage that would cover $100,000 per person injured, $300,000 maximum per accident and $50,000 per accident property damage.  If you have questions about what your coverage amounts are, I have found that brokers and insurance representatives are generally reliable and informed on this topic.  If there is some aspect of the insurance that is particularly important to you, you might ask the broker to email or write to you to confirm in plain English what that coverage means.  You have to evaluate how much coverage you need as well as the premium costs for different coverage amounts.  Sometimes, for not much more money, you can obtain significantly better coverage and sometimes you realize the coverage is too pricey.

Rating Agency	Rating Scale	“Secure” Ratings
A.M. Best	A++ to F	A++, A+, A, A-, B++, B+
Fitch	AAA to C	AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-
Moodys	Aaa to C	Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2
Standard & Poors	AAA to D	AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-

So, as you are evaluating your insurance choices, you need to take into account both the premium amount and the financial strength rating.  Often stronger insurers charge higher premiums than less financially secure insurers.

How do you find out what an insurer’s rating is?  Typically it is on their website.  Here are some examples.

• American General Life
• Liberty Mutual
• MetLife

In today’s turbulent economic climate, it is a good idea to periodically check in on the ratings for your insurer and especially your bank!  While most insurers aren’t truly all that healthy right now, the U.S. government is standing behind them to help rebuild the credit markets.  Still, before you renew your next insurance policy, it might be worth a quick visit to check their financial strength rating.

What lessons have you learned about insurance?  Please share in the comments.

P.S. The incredible artist, Angie Jordan, wrote a blog post recently about the creation of the Ruly line art characters. Angie chooses one of her Facebook fans each month to receive a free digital caricature and I encourage everyone to “fan” her.