Having the right kinds of insurance is critical and really a sign that you are a responsible adult. Having the wrong kinds of insurance will just result in you throwing away money needlessly and make it hard for you to reach financial independence. The trouble is, there are so many choices out there and so many people trying to sell you this insurance package or that because they make a big commission when you do. It is really difficult to get good advice on insurance since most of the information you get on insurance comes from salesmen, many of them really not knowing anything more than they learned in a daylong seminar that probably was focused on how to sell insurance.
Insurance companies also make it purposefully complicated so that you won’t really know what you’re buying. They make up their own terms, like “deductible” and “copay.” They talk about allowed and unallowed losses. They’ll say it is an investment (no insurance product is an investment). All of this is designed to get you to hand over your money to them. Luckily, if you look at the concepts and mathematics behind insurance, it really isn’t all that difficult and you can figure out what insurance you really need and what is just a ripoff. To understand the difference, we’ll first need to discuss what insurance is and how it works.
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The basics of insurance
Let’s say that you live in a community of 1000 homes, each home costing $100,000 to replace. Looking back over the last 50 years, you find that an average of 10 homes burn to the ground per year. Because you don’t have an extra $100,000 sitting around to replace your home should yours be the one that burns next, you hatch a plan:
You talk to your neighbors and get them to agree to each pitch in some money each year into a checking account. If anyone has a home that burns down, they can use the money in the account to replace their home. But how much should each family contribute?
Well, since an average of 10 homes burn down each year, you’ll need to pay out an average of 10 homes x $100,000 per home = $1,000,000 per year. Since there are 1000 homes, if everyone pitched in $1000 per year, on average you should be able to cover the homes that burn.
But, some years 15 homes burn down while other years, only 5 homes burn down. Based on this, you might have everyone pitch in $1500 for the first five or ten years, enough to cover the worst case that you’ve seen of 15 homes burning, until you get enough in the checking account to cover the years when you have extra fires, then lower the contributions back to $1000 per year. If you go through a bad spell where the account starts to deplete, you might raise the rates again. If you have a lot of good years and the account swells, you might give everyone a break and cut back contributions.
Rather than just let that money in the account sit in checking, earning 0.01% interest, once you had a bit of a surplus you might move some into a money market account so you could start collecting 1%. If the surplus were big enough, you might move some of it into CDs and lock up the money in exchange for 2% or 3% interest. This would be for the surplus portion of your funds when you already have enough money in savings and checking to cover all of the claims in 90% of the years. If you had enough in the account that you might only dip into a portion of the fund every 100 years or so, during great fires where dozens of homes are destroyed, you might invest the money in stocks, earning an average of 10% per year.
Note that because the amount you’re paying is equal to the value of your home divided by the chance of a fire occurring at your home in any given year, on average you will pay out the full value of your home between the times that a fire actually occurs. This means that you could have just put the money away into a savings account, paying to rebuild your home whenever a fire occurs, and end up exactly even. Alternatively, you could just go uninsured, spending your money on whatever you wanted, and when the fire does come and it destroys your home, you actually would be no worse off than you would have been if you had been paying into the fund all along. The money you saved would equal the amount of money you lost when your home burned down. You might get really lucky and not have your home burn down at all, in which case you would get to have enjoyed all of that extra money without having to suffer the consequences of a house fire.
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The issue is that if you decide to not pay into the fund and are instead saving up, but your home burns down in the first year or two, you’ll only have a couple of thousand dollars saved up and not be able to rebuild your home. This means that you might be out on the streets, or you might need to move in with others, burdening them. This is the whole point of insurance: you pay into a fund where everyone shares the risk together so that the people in the population who are unlucky don’t need to suffer an unbearable loss, resulting in you either suffering greatly or becoming a burden on others.
Note that this is where the “responsible adult” part comes in. While you may have thought that it was great to “live for the day” or thought that you’d much rather spend your money on trips or dinners out than throw it into the housing fund, when you catch the short end of the stick and things go badly, you burden others if you don’t either have insurance to cover your losses or have enough money saved up to rebuild yourself. (This latter possibility is called being “self-insured.”)
So how does an insurance company come in?
An insurance company does exactly what you were doing as a group. They figure out what the chances are of a given event occurring and then set rates to make sure that they have enough money to cover all of the events that are likely to happen within most years. So, if the event would cost $100 and happen about once every 100 years, they’d charge at least $1 to insure against it. They sell enough policies to make sure that they will have enough people paying in who don’t suffer a loss to pay for those who do suffer a loss.
Because they want to make money for their service, insurance companies will charge slightly more than the amount that they expect to pay out in claims each year. And, just like our collection of homeowners, they’ll actually charge enough to build up their reserves to make sure that they can cover the really bad years. This is why many companies will increase their prices after a disaster like a hurricane where they end up paying out a lot of claims, depleting their reserves. Also, like the group of homeowners in our example, they invest the money they have in the account that they are unlikely to need to pay out claims so that they can earn profits on the money they have sitting idle in their accounts. In fact, most insurance companies make far more from their investments than they do from premiums they charge for insurance policies. The agents they have selling the policies make commissions from the sales, while the insurance company makes money investing the money they collect.
Now, if you’re worried about being gouged by an insurance company, you needn’t be so long as there are enough companies competing for your business and they are not engaged in price fixing or other illegal practices. If one company were to charge substantially more than they needed to pay out claims, pay for their buildings and staff, and make a reasonable profit, another would charge less for policies and take their customers away. It is possible for one insurance company to charge higher rates for a while, or maybe for a company to be able to charge more because its customers like the service they provide, but on average the rates will all be about the same since the cost of the policy is a strong consideration that people make when buying insurance. The fact that there are many insurance agents that are constantly shopping around for the best rates for their clients further helps prevent price gouging.
So why wouldn’t you buy insurance?
As discussed, on average you’ll just be paying enough money in premiums over a long period of time to equal any losses you will suffer. In fact, you’ll be paying a little more since you’ll need to pay commissions to the insurance agents, as well as salaries for all of the people who work at the insurance company and for all of those fancy buildings. This means that, on average, you would be better off if you can self-insure. In other words, just pay for things when bad things happen. In doing so, you’ll pay less over the long run (on the order of 5-25% less since you won’t be paying for someone else’s buildings, employees, and profit.) Plus you’ll get to invest the money when bad things aren’t happening and collect the profits instead of having some insurance company do so and make money on your money.
The trouble is that there are some times when the loss would be so severe that you would not be able to take the risk that it would happen without some sort of coverage. These are things like losing a home (unless you have enough money in the bank to replace the home many times over) or ending up in the hospital for a long period of time. For these things, insurance makes sense. There are also certain types of insurance, like auto insurance, which are required by law because without it too many people were getting into accidents and injuring people, but not having enough money to compensate the other drivers for their losses and injuries.
So what types of insurance should you have?
Here is a list of insurance that most people should have:
Homeowners insurance: Homeowner’s insurance pays to repair or replace a home due to many different causes. This is required if you have a mortgage and very advisable unless replacing your home would not affect you very much financially because you have so much money in the bank. Once you have millions in your stock portfolio, if your home is only worth a couple hundred thousand, going self-insured might be an option once your home is paid-off. Homeowner’s insurance does not insure against flood, so you should consider flood insurance too if you live where it floods.
Car Insurance: This covers you for medical and property damage in the event that you are at fault in a motor vehicle accident, damage your own car or get hurt, or are hit by someone who does not have insurance. This is required to cover the other person’s car and injuries by law. Having coverage on your own car is optional, however, provided that you don’t owe money on the car. It makes sense in some cases to not cover your own car, particularly if the car is inexpensive enough to replace that you are paying about as much in additional premiums each year as you would receive if the car were damaged. For example, if a car is worth $1000 but you are paying $200 per year to insure it. You might self-insure for property damage for even more expensive cars if you have a big enough portfolio. Insurance companies have actually discovered that people with good credit – the kind that would have multi-million dollar portfolios – have fewer accidents than those with bad credit. Given that many accidents even on a $20,000 car will only cost $2000 or less to fix, and that you would only pay if you are at fault or are hit by someone without insurance, not insuring your own car and driving carefully might be a good option if you’ve got enough money to self-insure.
Term-Life Insurance: This is insurance that pays your heirs if you die within a certain number of years (the term). This is needed if you have people who depend on you since it would provide the money they would need to pay for things should your income or support disappear due to your death. Normally a term of 15-20 years, which is long enough to pay off the house, get children out on their own, and hopefully build up a substantial amount of wealth, is sufficient. Many people carry some amount of term insurance even after they have enough money saved up to self-insure since it normally doesn’t cost too much while you are relatively young and healthy and it can help pay for things immediately after a death without drawing down other savings. As you get older and are more likely to die, the cost of term insurance rises substantially and no longer makes sense to carry.
Liability Insurance: This is insurance against lawsuits. If you have a substantial amount of wealth, you might become the target for a lawsuit that could remove a lot of that wealth from you should you get into a car accident, have one of your children’s friends get hurt while he/she is at your home, or have someone get injured at your business. You increase your liability if you engage in activities such as renting out property. It is not that expensive to get an umbrella policy, which kicks in after your standard insurance. This may make sense if you have enough wealth and/or are at substantial liability due to your activities.
Major Medical Health Insurance: This is health coverage that pays should you be hospitalized or for major events like cancer or an organ transplant. It is far cheaper to pay for things you will need like office visits, ear infections, etc… out-of-pocket since then you’re just paying the doctor instead of paying an insurance company, who needs to pay all of their staff, who then pays the doctor, who also needs to hire additional staff to file the insurance paperwork. You can actually find doctor’s who will give you a discount if you pay cash, so you should always ask for the cash price if you don’t have full-coverage health insurance or if you have a high-deductible plan. The time to ask is before a procedure is done, but sometimes you’ll get a break even afterwards if they have not filed with insurance yet.
Long-term Disability Insurance: This provides a payment to you for a long period of time should you become disabled. Given that your far more likely to be disabled than die, this is critical at least until you become financially independent and can self-insure. Most jobs offer coverage.
What Insurance should you probably not have
Whole life insurance (or anything but term insurance): This is a combination of term life insurance with a bank account attached. It sounds great because you get some money back later if you don’t die, but 1)the interest rate you receive is far less than you’d receive from investing the money in stocks or even in the bank, 2) it is far too expensive compared to term insurance to be worth the cost and 3) if you do die, your savings account is gone, as if it never existed. Your heirs just receive the face value fo the policy.
Supplemental health coverage: These are policies that pay out money when you get some specific illness such as cancer. I made a lot of money investing in AFLAC, but the truth is that your standard health coverage will cover you for things like cancer and you’ll do far better saving up money to pay for expenses should you get sick than you will sending away premiums to the AFLAC duck. It sounds good in principle and you’ll probably be happy to have such insurance if something happens, but you’re really wasting your money since, most of the time, you’ll pay far more in premiums than you receive in payments.
Extended warranties: That extra few dollars that the store asks if you want to tack on at the register is actually an insurance policy. Like all policies, they’ve done the math and have figured out that you’ll spend a lot more for the policy than they’ll pay out. Plus, when something does happen, you’ll need to jump through all sorts of hoops to get the coverage, like sending a heavy TV through the mail at your expense. You’ll probably wish that you had bought a warranty if something does break right after the manufacturer’s warranty runs out, but there will be many, many times when things either break while they’re still covered by the manufacturer or don’t break during what would have been the extended warranty.
Renters Insurance: This pays for your property should you experience theft, fires, or other events while renting. Since your landlord covers her building, but not your stuff , renter’s insurance may seem appealing. Most of the time, however, the sum total of your property during the periods in your life when you’re renting is not large enough to represent a huge hardship should something happen and the chance of losing everything is very low. It is better to just save the insurance money and be cautious. If you live your whole life renting because you’re in a high cost city and start to accumulate hundreds of thousands of dollars worth of stuff, renter’s insurance might start to make some sense to protect from fire.
Accidental Death and Dismembership Insurance: If you have enough life insurance, there is no reason to pay extra for the off chance that you’ll be killed in an airline crash. If you have a long-term disability insurance, you’ll be covered if you lose both arms and can’t keep working. Instead of buying thisinsurance, increase your term life insurance amount if you’re worried.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.