The concept of insurance goes all the way back to Hammurabi, the ancient Babylonian king who was the first to write (or more accurately, carve) a set of laws to govern commercial interactions. Since that time, systems of insurance have continued to grow and develop along with society. Today, we consider insurance a basic element of personal financial stability, the growth of national economies, and the success of investors.
What Is Insurance?
Let’s start by explaining insurance in a nutshell. You pay a monthly fee to your insurance company and if you experience unexpected loss or damages, they cover the cost. The agreement between you and the insurance company is called the policy and the amount that you pay each month is called the premium. Most insurance policies also have a deductible, or an amount of money you are required to pay out-of-pocket, and a policy limit, which is the maximum the insurance company will have to pay in damages.
This basic structure of protection is one of the fundamental cornerstones of financial stability. True, there might have been a time in your life when you scoffed at the thought of having to pay a bill for something you might not use. Perhaps even now, you let out a bit of a moan when your insurance bill arrives. But at the end of the day, no one wants to be caught without insurance.
Insurance as a Safety Net for the Individual
When you think of insurance, you usually think of life insurance, homeowners insurance, or auto insurance. These are insurance policies that you buy to secure individual assets. If you total your car in a car accident, your auto insurance will cover the cost so you can get back behind the wheel. If you break your leg while attempting a high jump on the ski slopes, health insurance will pay for the procedure to reset the bone instead of shoveling out cash from your pocket.
In both of these instances, insurance secures your personal assets. But if you look a bit deeper, you'll see that the same insurance is actually ensuring the stability of the economy at large.
Insurance as a Protector of Stable Economies
While the nitty-gritty of insurance policies, deductibles and compensation is something that takes place on the individual level, insurance also protects the greater economy. If insurance didn’t cover the cost of that new car, you wouldn’t be able to get to your office across town and you could easily end up losing your job. If your car broke down and you didn’t have insurance, you could quickly go from being a part of a growing economy to being a drag on it.
Insurance also spreads risk from the individual to the community. When a child is building a tower of blocks, they need to start with a wide base — four blocks on the bottom, then three, then two, then one. The foundation has to be wide enough to hold the weight of the other blocks, so if one block moves a bit, the base can still hold up the tower.
Insurance companies act as the foundation of an economy by pooling individuals into a group who can absorb loss more effectively than an individual. Insurance transforms individuals into a collective group at the bottom of the block tower. It reduces the impact of economic setbacks by spreading risk across the population and enabling economies to invest in growth and innovation.
Insurance for Stock Investment Portfolios
While you can't take out insurance on your stock investments in the same way you can on your house or car, portfolio insurance does exist. If you hold a portfolio with a brokerage firm that goes bankrupt, losses up to half a million dollars are protected by the SICP. The SICP is a nonprofit corporation created by Congress to protect clients of brokerage firms that go bankrupt. The SICP ensures an environment where you can’t lose everything if there’s funny business going on like insider trading, selling unregistered stocks, or stealing customer funds. For the stock market to perform properly, there must be a level of investor confidence and SICP insurance creates that confidence.
How else can you secure your stock investments? The best way to lower your risk of losing money on the stock market is to build a diversified portfolio. Harry Markowitz, the inventor of Modern Portfolio Theory, proved that while individual assets within the portfolio might rise and fall, an intentionally curated collection of stocks will almost always show growth. By hedging your stocks against one another in a well-balanced portfolio, you create a self-insuring stock portfolio. No, it doesn't come with a contract like an insurance policy, but it still acts as protection against financial loss.
“Insuring” Financial Stability
“If you are not taking risks, you are not living.” There is a lot of truth in that quote, and it is definitely true that you need to be open to a certain level of risk when you’re investing. But not all risks are created equal. National Insurance Awareness day is on June 28th. Why don't you take the day to examine what financial risks you are taking intentionally and what risks you might be taking without really noticing. It's a healthy exercise that will help ensure you are on a path to financial security.