FOOL'S EYE VIEW
Why And When You Need Insurance

By James Carlisle
July 15, 2002

Insurance is all about collective enterprise and the sharing of risk. Its roots are ancient (see articles 23 and 48 of the Code of Hammurabi), but the modern-day commercial form is said to date back to seventeenth century London where merchants sat around waiting for their riches to be ferried back from newly-discovered exotic locations around the world. The trouble was that each of the merchants only really had the money for a few boats and, if one or two of them went down in a storm, then their entire business might follow suit.

The solution was for the merchants to underwrite each other's business ventures. So, if Sammy the Spice Trader had a ship due to bring him back cinnamon from Asia, he might get his mates to take a share of the risks in exchange for a small fee. The small fee was called an insurance premium and an entire industry was born.

Of course, the insurance underwriters would work it out so that they took enough risks on different ventures and charged enough of a premium that they made a profit, despite the fact that they'd take an occasional hit. The shipping merchants, on the other hand, would have to part with a small part of their profit in return for being certain of the rest of it. So everyone was happy.

Despite providing an interesting perspective on seventeenth century commerce, this tells us some fundamental things about insurance. To start with, we can see that the insurance underwriters -- insurance companies in today's world -- aim to make money from us. That's fair enough since they're taking on part of our risk. Why should they bother if they don't stand to make some money from us?

On average, therefore, insurance will cost us money -- but it's worth paying that money to protect ourselves from risks that we're unable to cope with. Where we can live with the risks, then why would we want to give money to an insurance company. Where we can't live with the risks, then why wouldn't we want to offload it to someone else.

Plugging the Gap

In effect, insurance is there to plug the gaps in your personal finances. For example, if you're the principal money earner in a young family that has little in the way of savings, then your premature demise would leave a large hole in your family's finances. Some form of life insurance would be essential.

However, at the same time as paying your life insurance premiums, you'd aim to be stashing away money into your savings. At some point in the future, there will hopefully come a time when you have enough stashed away so that your family (who will eventually become less of an expense anyway) could make do on the savings if you shuffled off early. The gap in your finances would no longer be there and the life insurance would no longer be necessary.

What about the much-maligned (and rightly so) mortgage indemnity guarantee (MIG)? It gets dressed up as a form of insurance to pay off your mortgage in case you default, but really it isn't protecting you, it's protecting the mortgage company against your being unable to play. It plugs a gap in their finances rather than yours and naturally you'd want to avoid it if you can (although it may not be possible if you're considered a high-risk borrower).

You can think of all types of insurance in this way. Household buildings insurance will be a must for almost all homeowners, because very few could afford the cost of rebuilding their home if it fell down. Household contents insurance, on the other hand, will vary more from person to person, depending on what you've got in terms of household contents and how much you've got in the way of savings.

If you could suffer a flood, fire, or burglary and replace all your contents without much of a drama, then you might decide to avoid the cost of contents insurance. However, if you're not yet at that stage, then you'll need the insurance because, without it, you'd be in big trouble if things went wrong.

Travel insurance, at least for medical expenses, is probably a must for almost everyone because few could afford to bear the risk of expensive medical treatment overseas. Beyond that, most of us only get to have one holiday per year and that makes it pretty important! If your holiday stands to be wrecked by the loss of your wallet or suitcase, then it might well be worth having some cover to get things sorted out quickly and easily.

The key point in buying insurance is to understand where the gaps are in your personal finances and get the cheapest suitable policy to fill them. If you buy insurance that you don't need, then you're wasting money. But if you don't buy insurance that you do need then, sooner or later, that decision will come back to haunt you - just like the seventeenth century London merchants that took a chance by not insuring their only boat.

More: Compare insurance policies online in the Motley Fool's Insurance Centre