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While value, affordability, risk exposure, and risk tolerance should affect insurance purchase decisions, insurance is often sold and purchased emotionally. Yet, insurance premium payments reduce personal funds that might otherwise be available for additional investments. Many people could spend all their net savings on insurance premiums and have nothing left to invest and to build an investment portfolio. The issue is where to set a rational rather than emotional balance between expected risk and return.
Risk and return tradeoffs between insurance and investments
Insurance affordability inevitably dictates that most people will bear some insurable risks without insurance coverage. Individuals may be more or less comfortable with this situation. Having a good understanding of one’s risk exposure and risk tolerance is a good start.
In general, individuals can significantly lower insurance premiums by focusing solely on buying catastrophic risk coverage and using self-insurance for more minor risks. For insurance you must have, shop around and chose high deductibles to reduce premium payments. Carefully evaluate the scope of coverage to assure that it is good quality catastrophic coverage. Then, invest the premium savings achieved through higher deductibles, rather than spending those savings. Over time, these premium savings and investment returns on them will build up your self-insurance asset pool.
Catastrophic personal events can drain assets and destroy the best of investment plans. Property, liability, life, and disability insurance can be rational purchases, because of risk pooling with other risk adverse people.
However, these types of insurance are not investments in and of themselves. Instead, they limit the financial impact of potential, but relatively unlikely, negative future events. The question comes down to finding good quality insurance at a competitive price and determining the tradeoff between money spent on premiums versus money retained and invested.
Optimal investment planning focuses on enhancing expected risk-adjusted portfolio performance. An optimal investment plan assumes that the necessary labor-based net income will be earned over time to build up your investment assets. In addition, the plan reasonably assumes that your assets will appreciate over time, albeit with substantial and unpredictable price volatility.
By adopting optimal investment practices, individuals increase the chances of financial success that can be attributed to investment returns. However, other risks are inherent in life planning, and there are no guarantees. Personal financial and investment plans [...]