Does rainy day fund recommendation assume appropriate insurance coverage?
Most financial advisers, blogs, personal finance websites, books, etc. all recommend a rainy day fund for individuals to set aside savings for a rainy day in addition to an emergency fund (i.e. unemployment). The question I have is: Does rainy day fund recommendation assume appropriate insurance coverage? Does emergency fund recommendation assume as well?
Resources about Rainy day fund and/or emergency fund
- BudgetsareSexy – J wants people to be proud of their emergency fund
- GetRichSlowly talks about the opportunity costs associated with an emergency fund and putting that capital to work
- The differences between rainy day fund and emergency fund can be seen here.
- MoneyUnder30 has an emergency fund calculator.
- There are also many other materials on this topic
The ranges of recommendations range for emergency fund from 6 months to 12 months of salary in savings set aside in a emergency fund. A rainy day fund is normally less for non-catastrophic related fund.
However, I rarely hear anymore details about having a personal catastrophe fund.
Again, the question I have is: does rainy day fund recommendation assume appropriate insurance coverage?
Risk – Uncorrelated or Correlated
Is the possibility that an individual has a loss or an accident have a higher correlation with their employment or lack their of? Is the possibility of lightning strike, earthquake, or flood to an individual home uncorrelated with their need of an emergency fund? Is there more risk for homeowners vs. renters? Less auto risk? Is the risk of illness changed?
Or is the inherent risk the same?
I would argue that it’s difficult to generally quantify the change in probability of a loss occurring during a period of unemployment for different people, however, it depends more on the expected length of unemployment and behavior of the individual during this period. Also any changes in behavior.
- In regards to length of UE, can the individual find a job easily or will they be on the bench for months?
- In regards to the behavior, is the individual driving less as they no longer commute to work?
- Are they stressed and less risk adverse?
- Are they selling assets and have less to insure?
In any scenario where an individual has a loss during a period of UE and they are drawing down on their emergency fund can be very stressful.
As the individual is depleting their emergency fund for living expenses, the probability of a auto, homeowners, umbrella, etc. claim may be unchanged (assuming no seasonality of claims). Therefore a claim could occur during a vulnerable time. It would be difficult to pay for a deductible loss or uninsured loss during this time.
In the event that an individual has a loss, an emergency/rainy day fund could be wiped out pretty quickly. 6 months to 12 months of expenses might not be enough – so this estimate might assume the insurance protection is appropriate.
I recognize, it is also difficult to increase insurance purchases and expenses during a period of unemployment. Most people probably look to reduce expenses. However, this expense reduction could be risky. Reducing coverage or insurance purchases can leave personal net worth exposed at a time when it cannot be afforded.
For example, failing to buy earthquake coverage or flood coverage when it is needed – could result in repairing a house after a natural disaster (when it is even more costly due to high demand).
Hence the need of a Personal Catastrophe fund.
Personal CAT fund/Risk Finance strategy
In addition to emergency fund and rainy day fund, I always held a personal catastrophe fund for non-insured loss as well as a strategy for Post Loss Funding. Luckily I didn’t need it, but I heard many stories of individuals during Hurricane Irene (2011) who were still unemployed and thankful they had flood coverage.
My Personal CAT fund strategy may be have been redundant but if the wrong insurances were purchased, I would hate to have experienced it during times of unemployment or financial stress on my family.
The good news is the Personal CAT fund if unused still can produce modest investment returns if done right.