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Financial Decisions – Risk and Reward

Almost every financial decision is a trade-off between reward and risk.  In this post, I’ll use three examples to illustrate how financial decisions can be made in a risk-reward framework.  The examples are:

  1. Deciding what to buy with some extra money.
  2. Selecting a deductible for your homeowners insurance.
  3. Choosing to invest in a bond fund, an S&P 500 index fund or the stock of a single company. I’ll use Apple as the example for the single company.

Trade-offs in General

Almost all financial decisions involve some sort of a trade-off.  In last week’s post, I used statistical metrics (e.g., standard deviation, probabilities and percentiles) to define risk.  Many financially savvy people use those types of metrics.  To get you more comfortable with the idea of this type of trade-off, I’ll use a subjective measure for the first example – deciding what to buy with some extra money.  I’ll then use statistical measures for the other two examples.

Trade-off – Purchase Example

Let’s assume your grandparents or parents gave you $1,000 for some special occasion, such as a graduation, birthday, or marriage.  You have decided to spend the money in one of the following ways.

  1. Spend $1,000 on a ski weekend.
  2. Spend $500 on a new Xbox and some games.
  3. Spend $700 on clothes.
  4. Spend $1,000 on the latest iPhone.
  5. Don’t spend any of it.

You plan to put any money you don’t spend in your Roth Individual Retirement Account (IRA) or Tax-Free Savings Account (TFSA).

In this example, I’ll define the trade-off as being between how much you enjoy your new purchase and its cost. You rank each option on a scale from 0 to 5 based on how much you will enjoy it.  You’ll want to consider the great feeling you’ll get from putting money in your IRA or TFSA, knowing that it will lead to an enjoyable retirement, as part of how much you will enjoy the options that include a contribution.

The table below might reflect your rankings:

Option Cost Enjoyment Ranking
Ski weekend $1,000 3
Xbox 500 4
Clothes 700 2
iPhone 1,000 5
Nothing 0 1

 

Your first inclination might be to select the iPhone because it will give you the most enjoyment. However, that doesn’t take into account the fact that it costs more than the Xbox and clothes.  Clearly, though, you prefer the iPhone to the ski weekend because you get more enjoyment for the same cost.

I always find it much easier to understand data in a graph than in a table.  The graph below shows the data above.

The x-axis (the horizontal one) represents the reduction in how much money you have after buying each item. That is, it is the negative of the cost of each purchase.  The y-axis (the vertical one) shows how much you like each item.   In this graph, you prefer things that are either up (higher ranking) or to the right (less cost).

Efficient Frontier Chart

The graph above is called a scatter plot.  In theory, there are dozens of things that you could buy, such as is shown in the graph below.

The blue dots in this graph represent the cost and your level of enjoyment of all of the options. The green line is called the “efficient frontier.”  It connects all of the points the meet the following criteria:

  • There are no other purchases with the same cost that you enjoy more.
  • There are no other purchases with the same level of enjoyment that cost less.

Making Your Choice

The “best” choices are those that fall along the efficient frontier.  You can reject any choices that aren’t on the efficient frontier as being less than optimal.

Going back to the first example, I added an approximation of the location of the efficient frontier based on the five points on the graph.

From this graph, we can see that any of buying the iPhone, buying the Xbox and some games or buying nothing are “optimal” decisions because they are on the efficient frontier.  That is, while the ski weekend has the same cost as the iPhone, you rated it as providing less enjoyment so the ski weekend is not optimal.  The clothes option is both more expensive and provides less enjoyment than the Xbox option, so it is also not optimal.

In this example, I have used the change in your financial position as the measure of “risk” and your level of enjoyment as the measure of “reward.”  Your own evaluation of the trade-off between risk and reward will determine which of the options you choose from the ones on the efficient frontier.

This example was intentionally simplistic to introduce the concepts.  I will now apply these concepts to two more traditional financial decisions – the choice of deductible on your homeowners (or condo-owners or renters) insurance policy and your first investment choice. My post about whether Chris should pay off his mortgage provides an even more complicated example.

Trade-Offs – Insurance Deductible Example

In this example, you are deciding which insurer and what deductible to select on your homeowners insurance.  For this illustration, I have assumed that your house is insured for $250,000 and you have a $500,000 limit of liability.  You have gotten quotes from two insurers for deductibles of $500, $1,000 and $5,000.  As discussed in my post on Homeowners insurance, the deductible applies to only the property damage coverage and not liability.

For reward, I will use the average net cost of your coverage.  That is, I will take the average amount of losses paid by the insurer and subtract the premium.  Because the insurer has expenses and a profit margin, this quantity will be a negative number.  Larger values (i.e., those that are less negative) are better (less cost to you).

For risk, I will use the total cost to you if your home has a loss of more than $5,000.  Your total cost is zero minus the sum of your deductible and your premium.  This number is negative (because outflows reduce your financial position) and larger (less negative) values are better.

The table below summarizes the six options and shows the premium, reward (average net cost) and risk (total cost if you have a large claim) metrics for each one.

Insurer Deductible Premium Average Net Cost Total Cost if You have a Large Claim
1 $500 $1,475 $-590 $-1,975
1 1,000 1,325 -530 -2,325
1 5,000 850 -340 -5,850
2 500 1,500 -615 -2,000
2 1,000 1,200 -455 -2,250
2 5,000 900 -390 -5,900

 

For each insurer, the premium and absolute value of your net cost decrease as the deductible increases.  The total cost if you have a large claim, though, increases as the deductible increases. When converted to financial outflows, the total cost values get larger (less negative) as the deductible goes up.

Efficient Frontier Chart

For the $500 and $5,000 deductibles, Insurer 1 has a better price.  For the $1,000 deductible, Insurer 2 has a better price.  These relationships can also be seen in the scatter plot below.

As with the scatter plot for the first example, points that are up and to the right are better than those that are down and to the left.  In this case, the efficient frontier connects the $500 and $5,000 deductible options for Insurer 1 and the $1,000 deductible option for Insurer 2.

Making Your Choice

Your choice among the three points on the efficient frontier is one of personal risk preference and your financial situation.  The $5,000 deductible option is clearly the least expensive on average, but you would need to be willing and able to spend an extra $4,000 if you had a large claim, as compared to the $1,000 deductible policy.  If you don’t have $5,000 in savings available to cover your deductible, that choice is not an option for you.

When I look at this chart, I notice that there is a fairly large reduction in the net cost from Insurer 1’s $500 deductible quote to Insurer 2’s $1,000 deductible quote.  If I have the extra $500 in savings to cover a loss if I have a claim, that looks like a good choice.  But, again, it is up to you to consider your finances and risk tolerance.

Trade-Offs – Investment Example

The same type of analysis can be used to evaluate different investment options.  As long as you are looking at publicly traded stocks, ETFs, mutual funds or one of several other financial instruments, you can get lots of data about historical returns from Yahoo Finance.  It is important to remember to let the historical data INFORM your decision, as the past is not always a good predictor of the future when looking at financial returns.

How to Get Data

Here is how I use Yahoo Finance to get data.

  • Go to finance.yahoo.com.
  • Find the Quote Lookup box. When I go to that site, it is usually on the right side of the screen below the scroller with the returns on various indices.
  • Type the symbol for the financial instrument for which I’m seeking data. Every publicly traded financial instrument has a symbol. For example, Apple is AAPL and the S&P 500 is ^GSPC.  I can also enter the name of the company or instrument, though it isn’t always the best at finding the one I want.  If the lookup doesn’t work very well, I use Google for the symbol of the company or financial instrument.
  • Click on the Historical Data button just above the graph with the stock price.
  • Select the time period over which you want the data in the pull-down box on the left. I usually want the full time series, so select Max.
  • Select the frequency on the right. I tend to be a long-term investor, so I always select Monthly.
  • Hit the Apply button just to the right of the frequency selection.
  • Hit Download Data just below the Apply button. It will ask you the format in which you want the data.  I always select Excel.  You’ll get a spreadsheet with one tab with your data on it.

There will be several columns in the spreadsheet that downloads from Yahoo Finance.  I usually use the Date and Adjusted Close columns.  Stocks can split (meaning you get more shares but they are worth less) and companies can issues dividends (which mean you get cash).  If I just look at the closing price at the end of each month, it won’t reflect splits. Since I’m interested in total return, I want my data to reflect the benefit of dividends.  The Adjusted Close column adjusts the closing stock price for both splits and dividends.

Investment Choices

In this example, we will assume that you have $10,000 you want to invest.  To keep the analysis somewhat simple, we will also assume that you are going to buy only one financial instrument.  In my next two post, I’ll talk about diversification and the benefits of buying more than one financial instrument.  The choices you consider are:

  • An S&P 500 index fund – an exchange-traded fund or mutual fund that is intended to produce returns similar to the S&P 500. Symbol on Yahoo Finance is ^GSPC
  • A Nasdaq composite index fund – an exchange-traded fund or mutual fund that is intended to produce returns similar to the Nasdaq composite. Symbol on Yahoo Finance is ^IXIC.
  • Fidelity investment grade bond fund – a Fidelity-managed mutual fund that invests in a basket of high-quality corporate bonds. Symbol on Yahoo Finance is FBNDX.
  • Tweedy Browne Global Value Fund – a mutual fund that focuses on international stocks.Symbol is TBGVX.
  • Boeing – A manufacturer of commercial and military aircraft. Boeing’s stock symbol is BA.
  • Apple – No need to explain this one! Its stock symbol is AAPL.
  • Neogen – A small company that develops and sells tests of food for pathogens. Stock symbol is NEOG.

Riskiness of Choices

Here is a box and whisker plot of the risk of these seven options.  See my previous post for a discussion of risk and box and whisker plots.

In addition to showing the 5th, 25th, 75thand 95thpercentiles, I added a blue horizontal line showing the average return over the 15-year time period for each investment.

Risk Metric – Standard Deviation

For most financial decisions, I look at the average result (e.g., average cost, average return, etc.) as my measure of reward.  As illustrated in the first example, you can use any measure you want, including a subjective one like how much you will enjoy something.  There are many, many risk metrics from which to choose.  If you are interested in overall volatility (deviations both up and down from the average), standard deviation is a good metric.

The chart below show the scatter plot of these investments using the average return as the reward metric and standard deviation as the risk metric.

In this plot, points to the right are better because they represent higher reward.  Points that are LOWER are also better, because they correspond to less risk.  I’ve drawn the efficient frontier for these points as being the ones that are furthest to the right and lowest on the chart.  Using these two metrics, the bond fund, Tweedy Browne (the international mutual fund), Boeing and Apple are on the efficient frontier.  If these metrics are right for you, the other investments are less than optimal.  The choice among the investments on the efficient frontier will be based on your willingness to tolerate extra volatility to achieve a higher average return.

Metrics – Probability of Negative Return

If your investment objective is capital preservation and you have a very short time horizon (one month in this example), you might want to look at the probability that the return will be less than zero in any one month as your risk metric.  (If the return is less than zero, your investment will be worth less at the end of the month than the beginning of the month.)

The scatter plot below shows how the location of the points changes if we replace standard deviation in the chart above with the probability that the return will be less than zero in any one month.

Using the probability the return is less than zero causes the S&P 500 to be even worse relative to the efficient frontier than it was when we used standard deviation.  The change in metric also causes Neogen to move down onto the efficient frontier and Boeing to move just slightly above it. These two charts show how our evaluation of the various options can change if we select different metrics.

On a side note, I want to alert you to the importance of looking at the scale of a graph.  The scatter plot below is identical to the one above except I have changed the scale on the y-axis.  Instead of starting at 30%, it starts at 0%

By changing the scale, I have made the differences in risk look much smaller in the second chart than in the first chart.  In my mind, the 31% probability that the monthly return will fall below 0% of the Bond Fund is significantly less than the 42% probability for Apple.  The second chart makes it look almost trivial. As you are looking at graphs in any context, you’ll want to be alert for that type of nuance.

Closing Thoughts

The goal of this post was to help improve financial decision-making process by providing insights into a helpful framework.  While you may not create graphs such as the ones in this post, you will be better able to think about risk, what features of risk are important to you and how to balance it with reward.  These new tools will help you make better financial decisions.

 

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6 Tips About Homeowners and Renters Insurance

Homeowners, condo-owners and renters insurance policies cover you for loss or damage to your property and liability that emanates from your residence.  All three policies cover your belongings regardless of where they are as well as injuries to others that happen at your residence. In addition, a condo-owners policy protects you against damage to the part of your condo that you own (generally the walls in).  A homeowners policy protects you against damage to your home and any other structures. While that seems quite straightforward, there are some nuances that make the coverage more complicated. In this post, I’ll provide you six tips that will help you better understand your coverage.  In the rest of the post, I will use the term “homeowers” to include both condo-owners and renters.

1 – Read your homeowners policy

If you’ve read some of my previous posts (such as this one), tip #1 isn’t a surprise!  An insurance policy is a contract and, like any other contract, I recommend you read and understand it.  To be clear, I’m referring to the 30-or-so-page document with the details of your coverage, not your declaration page which is the 2-3-page summary of what you bought.  I get a paper copy of each of my insurance policies every year. If you don’t get one in the mail, you may need to ask for one or visit your insurer’s website to get a copy.

With insurance, it is a little less critical to read the policy before you buy it, as there isn’t anything you can do to change the policy wording itself.  The wording of personal insurance policies is approved by the state or provincial insurance regulators.  Nonetheless, you’ll want to read your policy to make sure you understand what is and isn’t covered. An insurance policy is actually fairly easy to read.  My recollection from when I took actuarial exams a gazillion years ago is that the policy must be readable at the sixth grade level. So, while it has a lot of pages, it shouldn’t take you more than a half hour to read the policy (maybe a little longer the first time).

2 – Carefully check your declaration page

Your declaration page lists all of the coverages you purchased, the dollar amount of limit you bought for each coverage, the locations that are insured and any endorsements you purchased.  You’ll want to check this document before you buy.   Here are several things to check:

Is the location right?

It probably is. However, I reviewed a relative’s policy one time and saw that his rental property was missing from the declaration page.  If there had been damage to the rental property, my relative would have had to first prove that the insurer or agent made a mistake by not including the rental property and then could have made a claim.  Fortunately, by reviewing the declaration page for him, I found that the rental property had been omitted before he had a claim.

Do the limits make sense?

  • If you own a home or condo, does the structure limit seem reasonable?  Remember it is the cost to re-build your house or condo. For many years, that amount was much higher than I paid for my house, as existing homes were much less expensive than building a new home.  In “hot” markets, the re-build cost could be lower. So, be sure to think about the re-build cost, not the market value.
  • Do you have any other structures, such as detached garages or workshops?  If not, you don’t need much limit for other structures. If so, make sure the limit is high enough to re-build those structures.
  • How much would it cost to replace all your “stuff,” known as personal property?  In most jurisdictions, the personal property limit on a homeowners policy is automatically set to 50% of the limit for the house.  That amount may be right on average, but isn’t necessarily right for each individual. When I lived in California, housing prices were very high.  As a young homeowner, my personal property was not worth anywhere near 50% of the replacement cost of my home. For places with a very low cost of housing, the opposite can be true.  You can’t change the personal property limit in some jurisdictions, but it doesn’t hurt to ask if this limit doesn’t look reasonable. If you have a condo-owners or renters policy, you get to select the limit.  (In Tip 5, I talk about creating an inventory with photos. It will be helpful for estimating your limit, too.)
  • Do the limits on specific items, such as jewelry, musical instruments and collector coins, need to be raised?  Not all policies have the same items with these types of limits, so be sure to check your declarations page if you own any individual items or collections that are particularly valuable.  Most insurers can add an endorsement (essentially a few extra paragraphs that change the terms of your policy) to increase these limits.

    • Are there coverages you don’t need?

    There are a large number of other types of endorsements that either restrict or add coverage.  The names of the endorsements on your policy are listed on your declaration page and the wording should be attached to your policy form.  If not, ask for it! Take a look at these coverages to make sure that there aren’t any that you shouldn’t be buying. I had one relative who reviewed his declaration page and found that he was paying for sump pump failure coverage.  That endorsement covers repairs due to water seepage when a sump pump fails. His house didn’t have a sump pump, so the coverage was unnecessary. It is harder to figure out if there are endorsements you should have that you don’t. If you are insuring your first home or condo, you might want to talk to your agent or insurer to review the types of endorsements available to figure out which ones you might want to purchase.

    3 – Make sure you understand what isn’t covered

    A homeowners policy does not provide coverage against everything that can happen.  In fact, the policy includes a long list of causes of loss or perils that are not covered.  Many of them are not covered because they are under the control of the insured. That is, if the insured does something to cause a loss or neglects to do something that could have prevented a loss, it is considered intentional.  Intentional acts can’t be insured.

    Other perils, floods in particular, are not covered because the potential losses are considered (at least by the government) to be so widespread as to be too big for the insurance industry.  If you live in a flood zone, you can buy flood insurance from the National Flood Insurance Program.

    Some perils, such as earthquakes, are not covered because they are so expensive that insurers require you to purchase them separate from the rest of the policy.  By separating the very expensive coverage, the rest of the coverage becomes more affordable. When I lived in California, the cost of earthquake coverage was more than the cost of the rest of my homeowners policy.  In addition, the earthquake coverage had a 10% deductible. I chose to not buy the earthquake coverage because it didn’t fit in my budget. Fortunately, we didn’t have any earthquake damage.

    There are several sections of a homeowners policy that identify exactly what is and isn’t covered, so be sure to look for all of them.

    4 – Be aware of little extras that are covered

    You may be surprised by some of the costs that are insured under a homeowners policy.  You’ll want to make sure you are aware of them so you can recover the full amount you are due from your insurer.   One example is additional living expense coverage.

    Additional living expense coverage pays for the increase in your living expenses so you can maintain your normal standard of living if your residence is uninhabitable due to an insured peril.  It also provides coverage if you are required to evacuate due to an emergency. That is, if you need to rent an apartment for several months or stay in a motel for a while, it will be reimbursed by your insurer.  Any reimbursement will be reduced by the portion of your deductible that wasn’t used by the damage itself.

    As an example, there was a fire in a transformer in my mother’s condo building.  The building was declared uninhabitable for a little over a week. In addition, the smoke was bad enough that her walls, ceilings and all of her belongings had to be cleaned.  It turned out the ceiling had asbestos that had to be removed. The building insurance covered the asbestos abatement and cleaning, but she was responsible for the rest of her costs so submitted them to her insurer.  Her insurer not only paid to replace her belongings that were damaged by the smoke (such as her TV and computer), but also the cost of her plane ticket to my house for her initial evacuation period and the cost of a residential hotel for a month while her condo was cleaned and abated.

    There are several other such extras, including financial loss if someone forges your signature and worldwide coverage for loss or damage to your personal property (not just when it is in your home).  You can find out more about these coverages when you read your policy. (Hint, hint.)

    5 – Be ready if you have a claim

    A homeowners insurance policy has a list of duties for the insured in the event of a claim.  These duties include promptly notifying your insurer or agent, notifying the police if there is a crime and protecting the property from further damage.  When you have a loss, the insurer may send someone fairly quickly to help you prevent further damage, such as drying carpet and furniture to try to avoid having to replace it or tarping or boarding up windows or roof damage.

    Keeping an inventory of your belongings is one of the most important things you can do (and one that I have been remiss in doing).  If part or all of your residence is destroyed, such as in a fire, you’ll need to provide the insurer with a list of what was lost, including the quantity, replacement cost and age.  Obviously, it is impossible to keep a list of every item you own! The most important things to put on the list are those that are valuable – electronics, cameras, furniture, jewelry and watches, collectibles and the like.  It is particularly helpful, especially for unique items, if you take pictures of the items and the receipts and store them outside your residence (e.g., on the Cloud). If you have a loss, you will be able to access that information as documentation for the insurer.

    6 – As always, buy the highest deductible and highest liability limits you can afford

    A deductible is the amount that you pay on each claim before the insurer starts reimbursing you for your loss.  On a homeowners policy, the deductible applies only to the property coverages, not liability. When an insurer sets the premium for a policy, it has certain expenses and often a profit margin that are essentially percentages of the losses it pays to or on behalf of insureds.  So, if you buy a lower deductible, the losses paid by the insurer will go up. Your premium, though, will go up by the insurer’s estimate of the average amount of insured losses it will cover under the deductible plus the insurer’s additional expenses and profit margin. The additional premium could be 125% to 150% or more of the additional losses.  If you can afford to pay more on each claim through a higher deductible, you won’t have to pay the additional expenses and profit.

    If someone gets injured or dies due to a condition that exists at your residence, you may be legally responsible for their medical expenses, lost wages and other costs.  If those costs are more than your liability limit, you will become legally responsible for those costs. A higher liability limit can reduce your chance of becoming liable for these types of costs.  Of course, a higher limit also increases your premium, so you’ll need to evaluate both your deductible and the premium for a higher limit in the context of your budget.

     

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    Car Insurance Coverage

    If you own a car, you buy car insurance coverage.  In the process, you have to make lots of decisions.  Do you want to buy Comprehensive? Collision? What limit for Bodily Injury?  For Medical Payments? For Uninsured Motorist? What deductible? As with other insurance products, auto insurance is full of its own unique terminology.  In this post, I’ll explain all these terms and provide some insights on how to make some of the decisions that determine your car insurance coverage.

    As I told my kids (see Advice I Gave My Kids post), I recommend that you read every contract before you sign it.  Auto insurance policies don’t change all that much from year to year. If you use the same insurer and live in the same state, you can probably read the policy every few years to refresh your memory.  In the meantime, this post will help you understanding the basics.

    Before going into the coverages, though, I need to provide some background about liability and different types of laws governing the liability for car accidents.

    No-Fault vs. Tort Jurisdictions

    When you cause an accident in which someone else is hurt or their property is damaged, you have created a liability for yourself to reimburse them for their economic loss.  That is, you are liable for paying their medical costs and lost wages, among other things, and repairing or replacing their property. In some 12 states (see the chart at the end of this article for a list) and most or all of Canada, though, the laws make the driver of each car involved responsible for their own and their passengers’ costs in certain accidents.

    In the 1970s, car insurance costs escalated very rapidly.  No-fault coverage was introduced in some jurisdictions to slow auto insurance inflation.  In theory, under a no-fault system, every driver is responsible for the costs of themselves and their passengers regardless of who was at fault for the accident.  In practice, no-fault is applied to only “small” accidents. The definition of “small” varies widely across jurisdictions, with some defining it based on the total cost of injuries and damage and others based on the nature of the injury.  Jurisdictions that don’t have a no-fault system are often called tort jurisdictions.

    Tort Liability

    In a tort jurisdiction, you are required to buy Bodily Injury liability coverage.  In these jurisdictions, this coverage protects you against the cost of all injuries to others.  You will also be offered Medical Payments coverage which reimburses you for your and your passengers’ medical costs in accidents you cause.

    No-Fault

    Under a no-fault system, you are also required to buy Bodily Injury liability coverage to protect yourself against the cost of injuries to others, but only for accidents that aren’t “small.”  In addition, you will be offered Personal Injury Protection which covers injuries to you and your passengers in accidents you cause and in all “small” accidents caused by others.

    Coverage Overview

    The table below shows which of your coverages will protect you against costs from the people injured and property damaged or destroyed in an accident you cause.  I’ll describe these insurance coverages in a bit more detail below.

    Affected Party in an Accident You Cause Injuries – Tort Injuries – No Fault Damaged Property (cars, etc.)
    You and your family Medical Payments Personal Injury Protection (PIP) Collision
    Other passengers Medical Payments Medical Payments Collision
    People and things in other cars Bodily Injury (BI) Their PIP if small, your BI otherwise Property Damage Liability
    Pedestrians Bodily Injury Medical Payments Property Damage Liability

     

    Your insurance coverage is available to you regardless of whether you are driving your car or someone else’s car, including rental cars.  If you purchase Collision coverage, it will be cover the full amount of damage for any other vehicle you drive even if the other vehicle is worth more than any of your cars.

    Your coverage is also available to anyone else who is driving your car with your permission.  That is, unless someone steals your car, all of the coverages that you buy are available to another driver.  Loss or damage to your car due to theft is covered under Comprehensive.

    Bodily Injury Liability (BI)

    Bodily Injury liability coverage pays costs related to injury or death for which you become legally responsible because of a car accident.  Interestingly, passengers are not insured under Bodily Injury liability coverage but rather are covered under your Personal Injury Protection, Medical Payments or Uninsured Motorist coverage.  In no-fault states, the insurer pays only when the accident is severe enough to not be considered small.

    Property Damage Liability

    Property damage liability coverage pays the cost of damage to other people’s cars and property for which you become legally liable.  Most of the time, the damage is to other people’s cars and their contents. I know one person, though, who fell asleep while driving in a rural area.  She crossed the median, the lanes in the other direction and ran into the front of a store. Fortunately, no one was injured, but the store and its contents were damaged.  In this accident, her car insurer repaired the store and replaced its contents under her Property Damage liability coverage.

    Liability Limits

    You will have the option to select the limit of liability for your Bodily Injury and Property Damage liability coverages.  Coverage can be offered with split limits or a combined single limit (CSL).

    Split Limits

    When there are split limits, you will see three numbers, e.g., $100K/$300K/$50K.  The first number ($100,000 in the example) refers to the amount the insurer will pay for each injured person. The second number ($300,000 in this example) is the total amount the insurer will pay for Bodily Injury coverage for each accident.  The third number ($50,000) is the total amount it will pay per accident for Property Damage liability. When there is a combined single limit, the limit will be described using a single number. That number is the maximum amount the insurer will pay for each accident for all injuries and Property Damage liability combined.

    Combined Single Limit

    I usually buy a combined single limit, but recommend looking at different options to compare the pricing.  For example, if you can find $100K/$300K/$50K coverage for significantly less than a $300,000 combined single limit, you might want to buy the split limits.  I buy the combined single limit because there is more coverage if a single person is severely injured. For example, if only one person is injured in an accident I cause but that person has $250,000 of medical costs and lost wages, a $100K/$300K/$50K limit would cover only $100,000 of the $250,000.  A $300,000 combined single limit policy would cover all of it. Another reason I buy a combined single limit is that I buy an umbrella policy (which I’ll cover in a future post). My umbrella policy requires a combined single limit on my underlying auto policy.

    What Limit

    I always buy as much limit as I can afford (and, as I indicated above, started buying umbrella coverage when I could afford it).  If you injure someone severely in an accident, you are liable for the full amount of their medical costs and lost wages regardless of whether they are covered by insurance.  If someone has $250,000 of medical expenses and lost wages and the applicable limit on your policy is $100,000, they can demand that you pay the remaining $150,000 from your personal assets.

    Personal Injury Protection (PIP)

    Personal Injury Protection coverage (PIP) pays benefits to you and members of your immediate family when involved in an auto accident, regardless of who is at fault, in a no-fault jurisdiction.  You can be reimbursed for medical expenses, loss of income and funeral expenses.

    When I lived in a no-fault state, I bought a much lower limit for Personal Injury Protection than for Bodily Injury liability.  Most importantly, my family and I have always had health insurance and I had disability coverage. If you are severely injured in a car accident, your auto insurer pays first.  My health and disability insurance also provided coverage after my auto insurance coverage was exhausted. I suggest confirming with your human resources contact or health and disability insurers that you would be covered if injured in a car accident before making the same choice I did.  If not, you might want to consider buying as high a limit as you can afford.

    Medical Payments

    Medical Payments coverage reimburses medical expenses in an accident.  In all states, coverage is provided for passengers who are not family members and pedestrians.  In tort states, you and your family members are also covered.

    I probably don’t buy a high enough Medical Payments limit.  Until I wrote this post, I always focused primarily on my situation and selected my limit in the same way I did my Personal Injury Protection limit.  Now that I’ve thought about it more, I realize that I should also be considering my passengers and any pedestrians I might injure. They might not have as much health and disability insurance as I do, so I wouldn’t have a back-up if my Medical Payments limit was less than the cost of their medical care and lost wages.  If you have a lot of non-family-member passengers and especially if you drive other people’s children to school or activities, you might want to consider buying as much Medical Payments limit as you can afford.

    Uninsured and Underinsured Motorist (UM/UIM) Coverage

    If you, your family members or your passengers are injured in an accident caused by someone else, that person is liable for your medical costs and lost wages.  Unfortunately, there are many accidents in which the other driver’s Bodily Injury limit is less than your medical costs and lost wages or sometimes the other driver has no insurance at all (which is illegal in all US states and Canadian provinces, but still happens).  In those situations, your insurer will reimburse you for any costs you can’t recover from the other driver or its insurance under your Uninsured and Underinsured Motorist (UM/UIM) coverage. The maximum amount you can receive from your insurer is your UM/UIM limit.  Your insurer then has the right to try to recover any amounts it pays to you from the other driver directly.

    The selection of a UM/UIM limit is very similar to that of a Medical Payments limit in that you are buying protection for not only you and your family members, but also your passengers.

    Physical Damage Coverages

    Damage to your car from accidents you cause can be insured under Collision and Comprehensive coverages.

    Collision and Comprehensive

    Collision reimburses you for damage to your car when it impacts another vehicle or object or rolls over.  Comprehensive reimburses you for damage to or loss of your car from perils than a collision. Perils explicitly covered by Comprehensive are:

    • Missiles or falling objects
    • Fire
    • Theft
    • Explosion or earthquake
    • Windstorm
    • Hail, water or flood
    • Malicious mischief or vandalism
    • Riot or civil commotion
    • Contact with bird or animal
    • Breakage of glass (also covered under Collision if from an accident)

    In addition, many policies will also reimburse you for a temporary replacement for your vehicle until it is repaired.  My policy provides only $20 a day up to a maximum of $600, so the coverage would help cover the cost of renting a car but is not likely to be enough.

    A quick tip – Property Damage liability coverage is easily confused with physical damage coverage.  Property damage liability covers other people’s cars.  Physical damage coverage includes Collision and Comprehensive so protects your car.  I don’t recall all the details, but have an example to illustrate the difference.  One of my daughter’s friends was driving back to college late at night after Thanksgiving on an interstate.  She hit a deer and totaled her car. She had not purchased Comprehensive, so was afraid she was going to have to figure out how to replace her car on a very limited budget.  It turns out the deer had a hunter’s tag on it and had fallen off the roof of the hunter’s car. Because the hunter was responsible for the deer being in the road, she was fully reimbursed for the value of her car under his Property Damage liability coverage.

    Physical Damage – What to Buy

    Collision and Comprehensive coverages can be quite expensive.  On one of my recent policies, my Comprehensive coverage cost more than my liability coverages, while my Collision coverage cost is 2/3 of the cost of my liability coverages.  I note that I have selected a high deductible and drive moderately old cars. These coverages would be even more expensive if I drove newer cars or selected a lower deductible.  As such, it is very important to balance the benefits of these coverages with their cost.

    Physical Damage – Rules of Thumb

    I have a few rules of thumb I use in making my decision about whether to buy Comprehensive and Collision coverage and at what deductibles.  They are:

    • Never buy insurance on something you can afford to lose or replace.  For example, you might have an old beater car you drive only in the winter.  If you can afford to replace the car or have another car you can drive in the winter, you might not buy Collision or Comprehensive on that car at all.
    • Select the highest deductible you can afford.  If you can’t afford to replace your car, especially if it is new or your only vehicle, you’ll want to buy Comprehensive and Collision if it fits in your budget.  You can reduce the cost of these coverages by selecting a higher deductible. You can review your budget and your savings to see how much you can afford to repair or replace a vehicle if it is damaged or stolen.  This review can inform your selection of a deductible.
    • Always put Comprehensive and Collision on at least one car if you rent cars for personal use with any frequency.  As mentioned below, your car insurance will cover you when you rent a car up to the maximum coverage you have on any one vehicle.  If you rent cars for only a few days a year, the cost of the rental car company’s insurance will be less than the cost to cover one of your cars for physical damage.  My experience, though, is that rental-car companies’ insurance is very expensive and I can afford to put Comprehensive and Collision coverage on one of my cars for my annual cost of buying coverage on rental cars.

    Towing and Labor

    Some insurers offer to insure you against the costs of towing and labor if your car breaks down.  Examples of the labor costs that are insured under this coverage include unlocking your car, changing a tire, gas, oil or water delivery, and jump-starting your car.  To be clear, your car insurer will not pay for any repairs to your car once it has been towed. It just covers costs to get you off the side of the road.

    This coverage is very similar to what is available from such entities as the American Automobile Association (AAA) or the Canadian Automobile Association (CAA).  If you are interested in this coverage, you’ll want to compare the coverage and cost from your insurer with that from other entities. For example, depending on what level of service you buy, AAA will tow your car for either five or 100 miles.  By comparison, towing coverage under a personal auto policy is capped at the dollar amount of the limit you purchase. As you make the cost comparison, you’ll want to consider whether you use any “free” services from the other entities.  Also, if you buy this coverage, remember to use it if you find yourself stranded. I was so rattled by being forced off the road and onto the median by a truck in a couple feet of snow that I forgot I had this coverage. I ended up paying the tow bill myself.  Oops!

    Exclusions

    There are lots of exclusions in an auto policy.  Some important exclusions I have seen include:

    • You are not covered for intentional acts.  For example, if you are mad at another driver and intentionally run your car into the other driver’s car, your insurance company won’t pay for any damage or injuries.
    • You are generally not covered if you are using your car in a business related to cars.  Driving your car for Uber or Lyft or similar is almost always excluded. Also, if you park, sell or repair cars, any damage to or caused by those vehicles will not be covered.
    • You are usually not covered if you are driving a vehicle other than a car, pickup or van for any type of work.
    • You are not covered for injury to anyone who is your employee, unless it is a domestic employee.  We always added our nannies on our insurance policies as drivers to make sure there was no question that they were covered.

    Tips about Renting Cars

    Your auto policy will cover you and a rental car in the same way as it covers the vehicle on your policy that has the greatest coverage.  For example, let’s say you own two cars – a new one with $500-deductible Comprehensive and Collision coverage and an old one with no physical damage coverage.  Your insurer will provide $500-deductible Comprehensive and Collision on any cars you rent.

    The one exception is that many insurers won’t cover the charges from the rental company for the loss of use of its vehicle.   That is, the rental company charges the renter for the costs it incurs and the profits it loses because the car is being repaired and not available for rent.  These charges are known as loss-of-use charges. These charges can be very expensive, even more than the costs to repair the car. In all our years of renting cars, we have only had one claim.  One of our nannies left her purse in plain sight in a locked rental car when she took the kids to the beach. Someone broke the back passenger window to grab her purse. In that case, our insurer paid for the damage to the car under our Comprehensive coverage after we paid the deductible.  It also argued with the rental car company about the loss-of-use charges. In the end, we did not have to pay anything other than our deductible.

    When renting cars, I decline all of the insurance coverage offered, taking my risk that I might have to pay for loss of use.  But, I also make sure I always have Comprehensive and Collision on at least one car so that coverage and, even more importantly, the insurer’s leverage in negotiating with the car rental company are available when I rent cars.

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    Accidental Death & Dismemberment Insurance 

    Accidental Death & Dismemberment Insurance (AD&D) provides additional life insurance if you die in an accident. It also pays you a percentage of the face amount of the policy if you lose or lose use of a body part, such as an arm, a leg or an eye.  Many employers offer this coverage. Some charge for it while others do not.

    Business travel accident insurance is a form of AD&D, but only provides coverage if you are traveling for business when the accident occurs.  Some policies also provide coverage if the accident occurs on the employer’s premises. Most employers do not charge for this coverage, but some may.  

    How to Decide Whether to Buy AD&D

    I generally did not buy AD&D, though obviously didn’t opt out of them if my employer covered the cost. I had a desk job for my whole career, so could have gone back to work with at least some amount of disability.  

    If you have a career that is more physical, you’ll want to think about what injuries would make you permanently unable to pursue your current profession. You’ll want evaluate the amount of benefit that would be provided in case of loss or loss of use of a body part.  If your employer’s policy covers accidents in the workplace, you’ll also want to consider whether your workplace is dangerous, such as a manufacturing facility or an oil well, and, in the US, any recoveries you might receive from workers’ compensation insurance. As always, you’ll want to evaluate the potential benefits of this coverage in your specific situation relative to the cost of the insurance and whether it fits in your budget.

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    Group Life Insurance

    Many employers offer group life insurance on one or all of the employee, spouse and children.

    Coverage

    The type of life insurance offered by employers is called term life insurance. It will pay the stated benefit if the covered person dies during the policy period.

    My employers generally provided life insurance on the employee with a benefit amount equal to one year’s salary at no charge.  I was able to purchase more insurance on my life and smaller amounts on my spouse and children.

    Exclusions

    Group life insurance won’t provide the stated benefit if the cause of death is excluded from coverage. The most common exclusions with which I’m familiar are suicide and murder by the beneficiary.

    If these nuances are important to your decision, you’ll want to ask your human resources representative what exclusions exist under your employer’s coverage. Much more importantly, if you are concerned about your mental health or your physical safety, please seek help! There are free crisis lines that will help with either issue or contact your local hospital for mental health concerns or police for safety issues.

    How to Decide About Yourself

    Whether to buy life insurance is often a tough decision, as we all like to think we will still be alive at the end of the year. We especially don’t want to think about what will happen if we or a loved one dies.  

    With respect to your coverage level, you’ll want to think about whether you have any dependents and, if so, whether they’ll be able to sustain their current lifestyle without your income and personal expenses. If you have no dependents and very little debt, you might not need more life insurance than one times your salary.  On the other hand, if you have children, have some or a lot of debt or are barely covering your expenses, you might want to buy more life insurance to make sure there is money to pay down your debts or support your children if you die.

    You’ll also want to consider the cost of the life insurance and whether it fits in your budget. For more information on budgeting, see my introductory post and nine-part series with step-by-step details to create a budget, starting with this post.  If buying life insurance means that you don’t have enough money to cover the basics, you might need to take the riskier approach and not purchase life insurance or not purchase as much.

    How to Decide About Your Spouse

    The considerations for insuring your spouse are similar to buying insurance for yourself.  You’ll also want to consider whether your spouse’s employer provides any life insurance and compare the face amounts offered and premiums between the two plans.

    How to Decide About Your Children

    The amounts of insurance available for the death of children are usually relatively low, in the range of $5,000 to $20,000.  I view the primary purpose of buying life insurance on children as covering funeral and related expenses. If you are able to afford a funeral and everyone who “should” attend can afford to do so, you are less likely to need life insurance on your children.  However, funerals and travel can be quite expensive, so life insurance on your children could cover some or all of those expenses. As always, you’ll want to evaluate whether the cost of life insurance on your children fits in your budget.

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    Disability Insurance

    Disability insurance replaces a portion of your wages if you are sick or injured.  In the US, where workers’ compensation insurance covers workplace illnesses and injuries, disability usually covers only non-occupational illnesses and injuries.

    Types of Disability Insurance

    Many employers offer wage replacement in a number of components.

    Sick Time or Paid Time-Off

    Many employers provide sick time or paid time off benefits that pay you 100% of your wages when you are sick. There is often a limit on how many days of sick time you can take. More recently, vacation dates are included in the limit and the total is called “Paid Time-Off.”

    Short-Term Disability Insurance

    After a stated waiting period called an elimination period, short-term disability insurance will replace some or all of your wages.  I have seen short-term disability plans that pay between two-thirds and 100% of wages (excluding bonus) for between 13 and 26 weeks. I have never had an employer charge me for short-term disability insurance, but imagine some employers might do so.  Some governments outside the US, including Canada, offer programs similar to short-term disability. If your employer requires that you pay some or all of the premium for a short-term disability program, I suggest you research the benefits provided under any government program in your decision-making process.

    Basic Long-Term Disability Insurance

    After you have exhausted your short-term disability benefits, you may be eligible for long-term disability benefits if offered by your employer.  The basic long-term disability plans I have seen have paid between 50% of salary to two-thirds of the sum of salary and target bonus. Some long-term disability plans provide benefits for only a limited number of years while others will provide benefits until your normal retirement age.  In all cases, benefits stop, of course, if you recover and are able to return to work. I’ve had employers fully fund basic long-term disability and others that required that I share a portion of its cost. If you pay some or all of the premium for long-term disability insurance, the corresponding portion of any benefits you receive are not subject to income taxes.

    Supplemental Long-Term Disability Insurance

    Some employers give you the option to increase the percentage of your income that is replaced by long-term disability at your expense.

    How to Decide

    The decision whether to purchase any optional coverage depends on two key aspects of your financial situation. Are you able to support yourself and your family if you are ill or injured for a long time? Does the cost of the disability insurance fits in your budget?

    At one (pretty unlikely) extreme, you don’t need to buy additional coverage because you have enough savings for retirement, any children’s education and even more or you could maintain your current lifestyle on your savings or your spouse’s income.  At the other extreme, you might find it difficult to afford disability insurance. In that case, you probably are also in the greatest need of it as one missed paycheck could be devastating financially. As such, the decision to purchase disability insurance is a balance between your need for the coverage in case you can’t work, your likelihood of having an accident or becoming serious ill and your ability to pay the premium.

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    Dependent Care FSAs

    Dependent care flexible spending account (FSAs) allow you to set aside a portion of your paycheck without paying any taxes on the money. You must use the money to cover out-of-pocket expenses related to care of dependent children or parents that allow you to go to work.  You do not pay Social Security or Federal income taxes on money put into or withdrawn from a dependent care FSA. In many states, you also do not have to pay state income taxes.

    There are restrictions on the types of expenses you can pay from your account. You can generally pay for child daycare (both traditional daycare and nannies), elder care, before-and-after school programs and sick childcare services, among others.  If you plan to use the money for other services, you’ll want to confirm that they are acceptable. This publication from the IRS web site provides lots of details about who can qualify and the types of expenses that are acceptable.

    You lose any money money you contribute to a dependent care FSA if you don’t spend it in the same year.  For most people, the 2018 maximum contribution was $2,500 if you were single and $5,000 if you are married. If your dependent care expenses are highly likely to exceed that limit, the tax savings make it reasonable to contribute the maximum.  If your expenses are likely to be less, you’ll need to take care in selecting the amount of your contributions.

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    Extended Health Care Insurance (Canada)

    In Canada, many of the basics of healthcare are provided through the government health plan.  However, many important expenses are not covered, including prescription drugs, medical devices (e.g., crutches, wheelchairs and orthotics), various practitioners (e.g., chiropractors, physiotherapists and psychologists) along with many other types of medical expenses.  Extended health care insurance covers a portion of these costs, with the portion and specific costs covered varying from plan to plan. Other features of some plans include dental and vision coverage, the portion of ambulance services not covered by provincial insurance and semi-private hospital rooms.  The insurance includes many of the same coverage terms used in US health insurance. If you are considering the purchase of extended health care insurance, I suggest that you read my Health Insurance post, excluding the sections on HealthCare Flexible Savings and Health Savings Accounts.

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    Dental Insurance

    Dental insurance pays for preventative dental services (usually two to four cleanings per year), a portion of other dental expenses (fillings, crown, root canals, for example) and sometimes orthodontia. The amounts of these expenses covered depends on the deductible and coinsurance.

    Every dental insurance plan I’ve had offered by employers has had a very low maximum, such as $1,500 or $2,500.  This coverage differs from most other insurance products. Most other insurance products protect against things you can’t afford to lose, such as the injuries caused by a car accident or a tornado that destroys your home.

    Dental Insurance Cost Comparison

    Because dental insurance has such low limits, it doesn’t provide much protection against large dental bills. As such, the decision to purchase it is primarily a comparison of your premium with your covered expenses. Each year, I estimated my family’s dental expenses by type.  That is, I considered how many family members get regular cleanings, what the visits would cost and how many of my children had braces.  For this part of my analysis, I ignored all other dental expenses, such as fillings or root canals.

    My dental plans always had the same coverage in and out of network, so the cost analysis was straightforward.  Before doing any sort of cost-benefit analysis, you’ll want to make sure you understand how in- and out-of-network dental expenses are treated, determine whether your dentist is in the network and reflect the impact on your covered expenses.  I applied the deductible and coinsurance to the expenses and compared the amount I estimated I would recover from the insurer with the premium. Networks, coinsurance and deductibles are all covered in my post on health insurance.

    Discounts negotiated by the dental insurer with providers are another component of savings.  Similar to health insurance, the cost of dental services provided by in-network providers when you have dental insurance can be significantly less than the cost if you don’t have insurance.  This savings is difficult to quantify initially, but you can estimate it once you have used the same provider under a single dental insurer for a year or two. You can then include those savings in your analysis as a cost covered by the insurer.

    How to Decide Whether to Buy Dental Insurance

    If the premium and amounts covered by the insurer were fairly close or the premium was less, I would buy the dental insurance.  If the premium was significantly more than the covered expenses, I usually took my chances that no one would need any expensive dental work.

    As with all other financial decisions, the risk-reward trade-off is an individual one so you will need to decide for yourself how much extra premium you are willing to pay to have a portion of unexpected dental expenses reimbursed by the insurer.  As you do so, remember that there is likely a fairly low cap on the total coverage provided by the insurer, so you’ll want to see how much of that maximum you’ll use up with your preventative and orthodontia expenses in evaluating that risk-reward trade-off.

    Acknowledgements

    I again want to thank Laura Kenney for her invaluable help with this post.

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    Vision Insurance

    Vision insurance is generally covers the basics – eye exams related to vision correction, glasses and contact lenses – and doesn’t usually cover more serious eye conditions.  As an aside, you should be aware that some eye conditions are considered medical in nature and are covered by health insurance. If you have an eye condition, I suggest contacting your health insurer to see if it is covered as a medical condition.

    Networks of Providers

    Vision insurers usually create a network of providers. My experience is that there are huge differences in coverage in and out of network, so you’ll want to see whether your providers are in or out of the network. I ran into a situation in which my eye clinic was listed as being in network, but it turned out my specific eye doctor was not. As such, it might make sense to call your eye doctor’s office before selecting vision coverage to confirm whether your specific provider is in your network.

    Cost Comparison

    The decision whether to by vision insurance is fairly easy. You want to answer the question, “Will I recover more than the premium?” I start by making a list of my expected annual vision expenses, including how many sets of glasses and contact lenses each person in my family is likely to need. I then apply the co-pays, deductibles and/or coinsurance to see how much I will receive from the vision insurer. See my this post on Health Insurance if you aren’t sure how co-pays, deductibles and coinsurance work.

    I am also aware that some health insurance plans cover a basic vision exam. You’ll want to research whether your health plan includes that benefit. If your health insurance plan has that coverage (and your provider is in your health insurer’s network which will likely be different from the vision insurer’s network), you’ll want to exclude any recoveries from the health insurer or exclude those expenses from your list before estimating recoveries from your vision insurer.

    How to Decide

    I compare the total amount I estimate I will recover with the premium.  If the premium is less than the recoveries, I purchase the coverage; otherwise I don’t.  Many vision insurance plans do not cover anything other than preventative services, glasses and contact lenses.  As such, the decision to purchase vision insurance is often a straightforward cost-benefit comparison and is less focused on risk and reward.  Of course, if your plan covers other eye issues, you’ll want to take those into consideration in your decision-making process.