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Can You Survive a Financial Catastrophe?

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Most financial experts recommend having an emergency fund – enough money to prevent a small emergency from becoming a major emergency. While most experts recommend you have an emergency fund, not all experts agree on how much you should keep in your emergency fund.

Some experts recommend a month of living expenses, and some recommend as much as six months living expenses. But the word emergency usually refers to something that requires immediate attention, and is relatively short lived.  Somewhere between one and six months, the word emergency changes to catastrophe.

Can You Survive a Financial Catastrophe?

flood catastrophe

Are you prepared for a financial catastrophe?

There are many events that can have a catastrophic effect on your finances. However, many of them are avoidable or can be mitigated with insurance. A fire, flood or other natural event could destroy your home, but if you have homeowner’s insurance or renter’s insurance, you may be covered for the loss of your home or belongings. Similarly, full coverage insurance on your vehicle can go a long way toward covering your losses. In these cases, you will most likely only have to pay your deductible and you are on your way. Hopefully your emergency fund is large enough to cover your insurance deductibles and any associated costs.

Issues pertaining to health and loss of life a very different from the loss of your home or belongings, especially since they have a more personal aspect to them. These events aren’t pleasant to think about since the affect the people we love, but again, the financial aspects can be minimized through health care insurance, disability insurance, long term care insurance, or life insurance.

As noted above, insurance policies can cover the majority of your losses and your emergency fund is there to help you through the rest of the emergency. Hopefully, your combined emergency fund and insurance policies will help prevent your emergency from mutating into a financial catastrophe.

But even with the many types of insurance plans available, there are some events that can escalate from an emergency to a catastrophe. It could be a lack of insurance coverage, a combination of events, or something many people underestimate: unemployment.

Would Unemployment be Catastrophic to Your Finances?

Unemployment is one of the most difficult financial challenges people can face. The first, and most important reason, is the loss of income. The second reason, is that most people simply aren’t prepared for unemployment. Many people underestimate how long it will take them to find a new job to replace their lost income, or they overestimate how much assistance they will receive from unemployment insurance benefits.

The maximum unemployment insurance benefit varies by state, but $400 per week is near the national average (and yes, you have to pay taxes on unemployment benefits). The amount of benefits received can also vary depending on the income the recipient was making before they were unemployed, how long they have been paying into the system, whether or not they have received benefits recently, etc. This sudden decrease in income can be devastating to one’s financial situation if it is prolonged. Could you handle an income drop from $5,000 per month to $1,600 per month? What would it do to your budget? How long could you last before it became catastrophic?

Do You Need a Personal Catastrophe Fund?

A personal catastrophe fund is basically the same thing as an emergency fund, but on a larger scale. It should be designed to help you replace a larger amount of lost income for a longer period of time than a standard emergency fund (remember emergencies are immediate, and catastrophes are larger and more drawn out). So the question is, do you need one, and if so, how large should it be?

Do you need a catastrophe fund? Not everyone needs a personal catastrophe fund fund. For example, if you are well insured, have a sizable emergency fund, and your income is very secure, then you might be well prepared (financially) for anything life throws at you. But you may wish to start a catastrophe fund if you don’t have enough or aren’t able to purchase the right insurance policies, or if your job is high risk. Here are some questions to ask yourself:

  • Do you have sufficient insurance? If not, can you purchase it?
  • How long will your emergency fund last in a worst case scenario?
  • How large are your fixed expenses?
  • Do you have additional investments you can sell? What about home equity you can tap?
  • How stable is your job? Your industry?
  • How long will it take you to find another job?

How large should your catastrophe fund be? The answer to this question will vary by person. Again, you want to consider your insurance policies, overall health, the size of your emergency fund and how long it will last, additional investments you might be able to tap, your fixed expenses, your career prospects if you lose your job, etc. If you believe your situation adds up to a higher risk profile, then you may wish to start your savings at 6 months worth of living expenses, and add from there.

What do you think about a catastrophe fund? Necessary, or over the top?

Photo credit: Adrian Snell


Published or updated August 31, 2011.
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{ 6 comments… read them below or add one }

1 krantcents

We keep a very low lifestyle profile. It also helps that I have no debt except for a small mortgage. Could I survive a financial catastrophe? Yes, but I would have to make changes. Life would be different!

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2 Ryan

I’m working on doing my best to be in the same situation. Our only debt is a mortgage, but we also have our everyday living expenses to consider, such as or utilities, insurance policies, food, etc. My goal is to minimize our fixed expenses as much as possible. That by itself can go a long way toward stabilizing your finances.

In many cases, I think the lifestyle one lives plays an important part in being able to avoid a financial catastrophe in the first place. For example, living from paycheck to paycheck dramatically increases the odds of an emergency becoming a catastrophe. That isn’t to say that all catastrophes are avoidable, because bad things can certainly happen to the best of people.

The idea is to ask yourself, what is the worst that could happen, and what can I do to get through that situation if it occurs? Then build a plan to handle those events – primarily through insurance, savings, and lifestyle changes.

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3 20 and Engaged

A catastrophe fund is absolutely necessary. Before, I thought 6 months was sufficient but now I’m seeing you should prepare for at least a year. What you said about unemployment insurance is so right: people overestimate the benefits they receive and underestimate how long it will take to find another job. Hopefully we’ll be in the position to build up a catastrophe fund, but we have to get out of it first.

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4 Ryan

I think this is more important now than it has been in years past, especially with unemployment near 9% and many people being out of work for a year or longer. Of course, it all depends on individual circumstances. It’s definitely worth reviewing your insurance policies and financial plan to determine how large of an emergency you can handle, and how long you can last under the worst case scenario.

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5 The Wealthy Canadian

My wife and I have recently purchased a few life insurance policies, and we have recently renewed our vehicle insurance. In addition, I opted for additional insurance coverage for my rental properties.

I think it’s important to be prepared for a catastrophe because it could take many months, if not years to recuperate if safeguards are not in place.

Nice post!

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6 PW

I can’t tell you how important an emergency fund is. In the Chicago area we recently got 8 inches of rain in 1 hr. We have lived in our house for 18 yrs and never ever had a drop of water in our finished basement (offices, family room, laundry room and utility room with furnace, hot water heater etc.) Sat. morn when a neighbor knocked on our doors to alert us to check our basements, I was in panic when I saw water and sewer back up all over our entire basement, yuk. Because we had an emergency fund, our entire block hired an expensive clean-up crew, and we also had water/sewer back up on our home insurance. But our losses exceeded the coverage. Our emergency fund kept us on our feet, and is paying for what the insurance didn’t cover. In total a $30,000 + loss for us. If we lost our furnace, washer/dryer we would have still had $ to replace them. I do an automatic transfer from my paycheck each month to Ing to the emergency fund and vacation fund. I had to use some $ from the vacation fund also. And hope we have time to build that back up to the 6-12 mo level. My husband lost his job end of June so vactaions will be short and cheap. We also used our emergency fund to put in a rather expensive anti-flood device which meant digging up our concrete floor in the basement so there is no chance of that happening again, as we now have to disclose this if we sell the house. I can’t tell you how important an emergency fund is. It is an absolute necessity, and we really do without buying a lot of junk to divert $ to the emergency fund, and just don’t go out to eat or waste $ to keep that $ flowing to the Ing accouts. Whew, was I relieved to know I could cover the flood loss.

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