We cover three broad topics in our comprehensive financial planning process: cash flows, contingencies and investments. We’ve talked about our cash flow system here and here. We’ve talked about our investment philosophy here and here. We think it’s worth discussing contingencies in more detail.
We think it makes sense to consider contingencies in relationship to their consequences and probability. In general, if the consequences are severe but the probability is relatively low, then insurance makes sense (see table below). Most other contingencies can be addressed through savings. We also think that it’s smart to coordinate risk management across both savings and insurance, because the more savings you have, the less insurance you’ll require. In our Hierarchy of Financial Needs, we think contingency planning is more important than investing because, when done well, it frees up incremental money to save.
Severe but Relatively Unlikely/Infrequent Contingencies
As most adults know, insurance requirements increase as our responsibilities grow. We typically recommend working with an independent insurance broker that can give you quotes from multiple providers for various applicable policies.
Term Life Insurance: Always consider whether there’s a genuine need. Who is the beneficiary? Do they really need money when I die? In general, if you have dependent children, you need term life insurance coverage. While the amount of coverage is subjective, it could be as high as 25x annual expenses plus additional amounts to cover contingencies like college education. Most people adjust the coverage to an amount that is affordable but still provides peace of mind. Laddering is often appropriate (e.g., $500k for 10 years, $500k for 20 years and $500k for 30 years), so coverage drops as wealth grows and kids age.
Disability Insurance: Prudent for those that have invested significantly in their education (e.g., doctors). We recommend “own-occ” policies with mental health and substance abuse coverage.
Health Insurance: While we typically don’t have much choice in our employer plans or healthcare exchange plans, some form of health insurance is almost mandatory. High deductible health plans (HDHP), which have become common, protect against the full cost of chronic disease and illness but leave us on the hook to pay potentially high out-of-pocket costs that can be addressed through HSAs or other savings.
Home Insurance: We recommend taking the highest deductible you can afford. Get enough coverage to enable the replacement of your home and possessions along with at least the standard liability coverage of around $300,000. While there are no good rules of thumb to suggest how much you should pay, we often use 0.5% of the home’s value per year as a rough starting-point guess. Homeowner's insurance is often a bit of an afterthought when buying a house, so make sure to periodically validate your choice and get quotes from multiple providers.
Car Insurance: As with homeowner’s insurance, we recommend taking the highest deductible you can afford. Typical 100/300/50 coverage means $100,000 per-person/$300,000 per-accident for bodily injury and $50,000 per-accident for property damage. Depending on your net worth and the value of your car, there may come a day when you can drop collision and comprehensive (theft/vandalism) altogether, but most people will need to maintain liability coverage.
Umbrella Insurance: Prudent and relatively inexpensive coverage against lawsuits for those that may be targeted based on profession or high profile. If umbrella coverage is desired, auto liability coverage may have to meet higher minimum requirements.
Severe but Likely/Predictable Contingencies
Events that are likely to occur, even if expensive, are often best addressed by savings accounts rather than insurance.
Long-term Care: We think self-insuring with an HSA or other savings, while financially challenging, is the best option. Most policies cover a finite number of days or years, so your risk is quantifiable. Saving enough to cover 3 years of local assisted living care is a good target.
Permanent Life: We think whole life and VUL policies are investments disguised as insurance; we’d avoid.
Somewhat Less Severe and Relatively Infrequent Contingencies
When the consequences of an event are somewhat less severe, it often makes sense to address the contingency through savings.
Emergency Fund: We generally recommend having cash readily available equal to 3-12 months of expenses, primarily to cover a short-term loss of income or gaps before insurance pays claims. High earners/savers can potentially use taxable investment accounts for emergencies. The amount needed will vary with age, responsibilities and risk tolerance.
Home Repairs: We recommend setting aside 1.0%-1.5% of your home’s value each year—depending on its age and condition—for potential repairs. You can also factor in some additional cash to cover deductibles on your homeowner’s insurance. We would avoid home maintenance plans.
Less Severe and Relatively Frequent/Predictable Contingencies
Many future expenses are foreseeable and can be addressed with savings relatively easily if we think ahead. These predictable expenses often end up becoming budget busters if not accounted for in your financial plans.
Out-of-Pocket Healthcare Costs: The severity of out-of-pocket medical costs will vary based on the type of healthcare insurance. HDHPs leave us exposed to high deductibles each year if we have chronic conditions. If possible, we recommend using HSAs for long-term retirement savings given their triple tax benefits and paying out-of-pocket healthcare costs out of a regular savings account.
Car Purchases: Calculate the amount to set aside each year based on planned replacement cycle and expected net purchase price (after trade-in). For instance, if your family has 2 cars, replaces each about every 10 years, and typically pays $25,000 net for the cars, the amount to set aside each year would be $25,000 divided by 10 multiplied by 2, or $5,000. You can also set aside additional money for repairs and deductibles.
Dream Home Downpayment: If you are contemplating buying your first home or upgrading to a dream home, you’ll need to save up for a potentially large downpayment and closing costs. We are not against long-term renting, especially in certain high-cost housing markets.
College Tuition: The amount to save is highly philosophical, but 529 plans are a great way to set aside money for kids’ education.
Other: There are many other foreseeable expenses that you might consider setting aside money for, including furniture, home remodeling, dream vacations, weddings, bar/bat mitzvahs and business opportunities.
Whether you develop a financial plan on your own or work with Aptus, it’s important to consider the multitude of contingencies in your life and how to best address each. A coordinated approach to risk will not only provide peace of mind but should also help reduce your spending on expensive insurance and increase your ability to save for retirement.