People Miscalculate Insurance Needs-How can understand of insurance?

After 30 years of teaching risk management, I have concluded that most people just don’t understand insurance. This repeatedly leads them to pay way too much to cover small known costs, while going without protection against the really big risks they face.

I call insurance for small predictable costs “haircut” insurance. That is, if you need to get your hair cut every six weeks like I do, you don’t need insurance–it’s not a risky expenditure. Nevertheless, people often do insure against low-cost predictable events.

In this category I put dental insurance that covers predictable annual cleaning visits: by self-financing your checkups, you can save enough to cover the cost yourself. But then the same people who buy checkup insurance also don’t read their policies to see whether expensive dental surgery is covered (and often it’s not!). Extended warranties on relatively low-cost consumer products are another example: why buy extra coverage for a kitchen microwave when the manufacturer’s warranty covers product defects anyhow, and most microwaves don’t break?

Along the same lines: most people pay too much for auto insurance when they elect low deductibles, towing, car rental, glass coverage and other features in their policies.  Yet they could save quite a lot in annual fees by upping the deductibles and dispensing with other frills–after all, the chance of needing these other services are low, and it’s probably more cost-effective to pay for it when needed. Same goes for homeowners insurance: You can invest the savings from a $10,000 deductible policy and make money on it, while retaining coverage for the big risk like a major fire, flood or earthquake.

Conversely, while paying for the small stuff, many students and colleagues forget about the big stuff. For instance, everyone starting a family after their baby was born–only to have her spouse perish in a motorcycle accident when she was in her 8^th month of pregnancy.

should buy life and disability insurance–before the family is launched! A woman I know told me she was planning on buying life insurance on her biker husband

Finally, one of the most critical risks you face is liability–the chance of being hit with a huge lawsuit from someone whose child slipped in your driveway and broke her neck. Despite the relatively low cost of a $1 million to $2 million policy, on the order of a few hundred dollars, few Americans understand how exposed they are to huge potential losses.

Insurance is best suited to help you finance catastrophes, not haircuts.

Olivia S. Mitchell is a professor of Business Economics and Public Policy at the Wharton School of the University of Pennsylvania where she focuses on pensions, household finance and risk management.