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Insurance: Never a Good Deal

Insurance. It's one of those things that most of us just see as necessary. In fact, in many cases, carrying sufficient insurance is mandated by law. You can't legally drive a vehicle without insurance, and I think that most of us would agree that it would be stupid to do so, regardless of the law. A single car accident could easily cost in the hundreds of thousands of dollars after property damage and medical care are taken into account. Most of us can't afford to pay hundreds of thousands of dollars on the off chance that such an accident occurs, so we pay our monthly premiums for a service that we rarely, if ever, use.

Insurance is one of those things where we consumers really don't have a whole lot of choice. Insurance companies are VERY good at being profitable, which is to say, taking in more money than they pay out; in other words, over-charging the customer to a large degree. If those profit margins start to slip, they can just raise the premiums. You don't have to be a rocket scientist to make big profits in the insurance industry, but they've got rocket scientist actuaries working there anyway.

Anyway, all of this is to say that the formula used by all insurance companies is like this:

(Sum of all money you pay to the company) < (Sum of all money you receive from the company)

Which in itself is just a complicated way of saying that insurance is never a good deal. At its basic level, you are not paying for a product or service from an insurance company. You are paying for money (actually, the chance at some money). Pure and simple. Yes, there is a bit of service involved, but this is pretty minimal.

In many ways, insurance is like the lottery. You buy a ticket for $1. So do a whole bunch of other people. Then the lottery pays one person a whole lot of money, and a few other people smaller amounts of money.... and most of the people end up with $0. But they still keep pumping their money into the lotto, because there's always that chance that they'll win.

In fact, at least the lotto has something positive for it. People play the lotto because they want to win. People buy insurance because they don't want to lose. At root, insurance is the industry of fear. "How afraid are you of losing $100,000? That's okay, just pay us $X per month and we'll make sure you never lose that $100,000. Only we've looked at the statistics and cooked the numbers so that we'll take in 3 times more than we ever have to pay out."

But of course, we all have fears, and it feels good to put them at ease. Also, bad things DO happen, or else insurance companies wouldn't be around at all. So it makes sense to have at least some sort of insurance. But you have to look at it from a rational, economic perspective.

In a recent post, Foobarista wrote about "cashflow preservation insurance" versus "wealth preservation insurance". I had never heard of this differentiation before, but it struck an immediate chord with me since a similar idea had been developing in my head for a long time (basically my idea was "certain kinds of insurance are a rip-off, but others make sense." I never had a rubric for separating the two other than my gut reaction).

o Wealth preservation insurance. This is a hedge against big, unknown expenses like getting sued or enormous medical bills.
o Cashflow preservation insurance. This is a hedge against "bump in the road" issues like car repairs or replacement of electronics or appliances.

Once it's put into such simple terms, it's easy to see what kind of insurance you should and shouldn't buy. "Wealth preservation" insurance: buy. "Cashflow preservation" insurance: don't buy. So do buy catastrophic medical insurance, malpractice insurance, auto liability insurance, landlord insurance. Don't buy comprehensive auto insurance, renter's insurance, extended warranties of any kind, etc. Things like homeowner's insurance (or maybe auto insurance for a really expensive car) sort of fall in between: get them, but with very high deductibles.

But again, insurance is never a good deal, even the "wealth preservation" kind. The game is still set up to take more money from you than it will ever give back. Really, the demarcation line between cashflow and wealth preservation insurance is simply a matter of your cashflow itself. As you get richer, you can afford to self-insure more and more of your things. For example, if you own 20 rental houses, you have much less need to insure them because you can afford to take a complete loss if one of them burns down (assuming that they're not all located right next to each other!). But if you own just one rental house, it represents a large part of your holdings, and you would be financially devastated by its loss. If your cashflow (aka disposable income) is $2000 a month, you are probably not going to want to insure your car with a $200 deductible. On the other hand, if you usually find yourself with $100 left over at the end of the month, a $200 deductible might seem reasonable.

Sorry for the long delay between posts. And sorry for the somewhat off-topic nature of this post. I'm really finding myself scratching my head to come up with more credit-related topics. I'm welcome to any suggestions. I don't mind covering more general personal-finance topics, but I would like to try to keep up the credit posts, if at all possible. But to be honest, from the beginning, I really saw this as more like a book than a blog. I only know so much about credit scores. I just wanted to take my knowledge and put it out there as sort of a reference. I really don't feel like repeating myself or beating a dead horse just to come up with new posts. So, readers, I ask you: what do you want to see out of this blog in the future?


Siggy said...

Not a bad analysis, but I think that you are being a little unfair to 'insurance'. In general, they are probably expected to bring in profits of about 5% In addition, the insurance company gets to use your money until a claim comes in and they invest this in a variety of ways (Berkshire Hathaway is basically the investment arm of Geico etc).

If you use insurance for major risks (wealth preservation, as you put it) with as high a deductible as you can afford, it provides a useful safety net that allows you to take more risks without compromising your security. This also applies to life insurance, although you should get TERM insurance only.

Nice and informative blog.


gagan said...

a good analysis of insurance but i guess its kinda essential expense for the most. It gives you a mental peace for a price. I know a few cases where insurance played a crtical role in covering up the losses.

plonkee said...

I think of useful insurance as what you buy when you cannot afford the alternative.

For example, I can't afford to replace my salary if I become permanently unable to work, so I have disability insurance. I also can't afford to rebuild my house, or pay for flood damage, pay for healthcare if I travel to the US. So I take out insurance against these things.

Anonymous said...

Yeah insurance is never a good deal, ask the Katrina survivors.

Oneqler said...
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