Friday, June 08, 2007

Good and Bad Insurance

Yesterday I recommended this article from Plus 6. The article lists 5 types of insurance that you probably should not buy. I would like to propose a much simpler test to determine whether an insurance policy is worth buying. Ask yourself the following question: "could I afford to replace the insured item myself if I do not have insurance?" if your answer is positive, you don't need to buy insurance.

My philosophy is that insurance is designed to protect you from catastrophic damage that you cannot afford to bear on your own. It is a method of spreading an unacceptable but rare risk over the entire insured population. For example, most people should probably buy flood insurance or home owners insurance, simply because in the event of catastrophic damage to their home, they would not be able to buy a new home or repair their severely damaged house without the proceeds from their insurance. However, an extremely rich individual, say Warren Buffet for example, should not buy home owner's insurance. If disaster strikes, he can simply buy a new house without financial hardship.

The thing you need to understand about insurance companies is that they are sophisticated. They have an army of statisticians and actuaries working for them and they have a much better understanding of the risk that you are facing than you do. Another funny thing about insurance companies is that they are not in business to lose money, and for the most part they are for-profit organizations.

Combine these two insights and you will understand the following: if you buy insurance your insurance premium will, on average, be higher than your insurance pay-outs. The insurance company, using its superior access to information, knows what the real risk is and is able to compute the likelihood that they will have to pay a claim against the insurance. They also know the average magnitude of that claim. When they understand the expected pay-out for claims, they add a certain profit margin and quote you a price for the policy you are asking for.

Follow this logic: the very fact that a for profit corporation gives you an insurance quote means that they have a profit margin built into the deal. It also means that your expected damage or potential claim is lower than the price you are quoted. On average, you will pay more for insurance than you will get in claims. The difference is the insurance company's profit.

In conclusion, insurance is an important financial instrument. However, you should only insure risks that you cannot afford to self insure against . In my opinion, insurance is best used to hedge against really catastrophic events that you cannot deal with yourself. Examples of good insurance: life, health, disability, homeowner's, professional liability etc. Examples of bad insurance: extended warranty, vacation insurance, and other types of insurance covered in Plus 6's article.

I am guessing this article will create a little debate. I have certainly had many arguments with people over the years regarding this approach. Let's see what the blogosphere thinks.


Kevin said...

You won't get any debate from me!

I tried to explain the fact that insurance in a losing proposition to a clerk at Circuit City trying to sell me an "extended warranty". I loved the look on his face... it seemed like he had never met someone before that new that "math stuff".

I'm big on the idea that insurance is ONLY for disaster. I carry the minimums needed to take care of big events. Collision and comprehensive insurance on a 1998 Sebring? I don't think so! $250 deductible on homeowners? No way! With all the money I save on insurance I'll always live better and be able to cover the little problems along the way.

plonkee said...

Actually I think travel insurance is pretty much a necessity - but when you consider that as a Brit I don't have health insurance, it falls more on the catastrophic side.

I basically agree, insurance is worth paying for when the event is rare but the outcome would be disastrous. Disastrous is defined differently for different people. If the event is reasonably likely, then you're probably better off self-insuring.

Anonymous said...

My father was an insurance agent before he died (ironically, he was underinsured). He always explained insurance as a form of gambling.

As an insurance company, I am wagering that you are not going to have a claim. Based on risk factors, I set the odds and you pay accordingly.

As the insured, you are wagering that you will have a claim. If/when you do, you collect. Of course, the insurance company will now reevaluate the odds and raise your premiums.

If you simply think of insurance as betting against yourself, you'll be a lot less likely to buy the insurance you don't need.

Bryan said...

No debate from me either. Always buy insurance to cover in terms of disaster which you can't afford to replace (Cover The need).

However instead buying what you need there are times where there are worth while products for you to take a look at. And that is when there are spare cash involved (the want).

And yes i am a insurance agent. Sometimes i may spot some products that are design and developed for consumers advantage (trust me there are such products) but only to be taken down after a week or so (i assume wrong product design on the insurer side).

Get what you NEED and watch out for what you WANT. That's my opinion.