Optimal Insurance For Investment For Beginners – A Real Informed Finance perspective
5 mins read

Optimal Insurance For Investment For Beginners – A Real Informed Finance perspective

Although the subject of ‘optimality’ has been approached from various angles in the past, this article discourses it from the practicality of what it entails – efficiency. I wish to introduce you to an economic concept from my background that succinctly resonates with optimality – pareto efficiency. Pareto efficiency, sometimes referred to as pareto optimality, refers to ‘the economic state where resources are allocated so efficiently such that it is impossible to make any party better-off without making another worse-off’.

The simple, actionable finance way; which we pursue here; is to approach optimal insurance from the purview of pareto efficiency. The optimal insurance for an investor refers to that level of insurance at which it would be impossible to make the investor better-off without hurting or jeopardizing their investment. The nuance of this approach is presented below.

Introduction – Background and Context

We live in a very dynamic world where the only certain thing is change. Such change often carries with it an element of risk. Professionally, we simply define ‘risk’ as ‘a deviation from the expected’; appreciating the fact that such deviation could either be positive or negative. It is thus we take up insurance to cushion ourselves against negative risks. Insurance “pools” or “aggregates” risks to ensure that negative deviations from expected are reasonably mitigated against; or compensated if and when they occur.

Why Insurance Is Necessary For Personal Investment

Today’s dynamic world encourages us to take proactive steps now to start personal investment; even with minimal budgets such as those for our grocery bills. With any investment comes expectations, that one will reap more in the future. But what if the tide turned against you in the future in this ever-changing world? That’s why we need insurance; especially on a personal level.

Instead of telling you the obvious that you need insurance for your health, education, car, employment et cetera, I prefer dissecting your insurance needs from Abraham Maslow’s theory of the hierarchy of human needs. Maslow talks of physiological, safety, love and belonging, esteem, and self-actualization needs; contending that we humans sequentially and chronologically fulfill our needs in that order. Once we set out to achieve the fulfilment of a certain category of needs we can then insure against any fallbacks; peradventure we face negative risks in the future and are unable to continue satisfying those needs. For example, property insurance for an asset whose income is used to meet recurrrent domestic expenditure is a prerequisite for personal investment; because if such property were to be rendered dormant one would be at loss covering their recurrent domestic expenses.

How to determine Optimal Insurance Level for Investment for Beginners

Here is the meat on the bone; how do we determine our optimal insurance level for our personal investment? Fret not, the theory behind it is simple, and the practice gets easier with realistic data to go with. By deducing from what’s stated earlier on pareto efficiency, we should theoretically insure up until the level where taking up any extra form of insurance would take away from our investment monies; either presently or in future.

Here’s the gist. If, for example, your employment insurance would pay your current salary (often less allowances) for six months if you lost your job today, then your optimal level of employment insurance should be limited to the present value of your basic salary and standard entitlements discounted over six months. In plain language, after making all logical assumptions on your risk of loosing your job, the amount you pay for employment insurance should not exceed the present value of your contributions to the insurance scheme before when you qualify for the employment insurance settlement.

From the example given above, you realize there is a lot of assumptions. That is what it normally is in practice; realistic data is always needed so that we can crunch the numbers to come up with a definitive figure “X” as your optimal employment insurance premium. What is sought, or must be revealed from the data, is inherent factors that would rapture the risk, in this case unemployment. Such inherent factors could, for example, include the probability of a professional in your industry at your experience level loosing their job, macroeconomic conditions (wage rates, inflation etc) and other factors that would impact the risk element.

Key Takeaways

It is worth noting that although “optimal insurance” concepts are fewer in practice and have a dearth of theory, proper nuanced insights would be a game-changer for most people. Like most economists contend the existence of pareto efficiency, most would still contend on optimal insurance. But just like economists who appreciate the contributions of pareto efficiency even if they dispute it exists, we should also consider the contributions of optimal insurance. We should thus consider our insurance premiums and how we finance them from a standpoint of optimal insurance. Nonetheless PESTEL (political, economic, social, technological, environmental and legal) factors should also guide us; for example, because health and social insurance are a mandatory legal requirement in some jurisdictions thus one would still have to pay them even if they are not optimal.

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