This article on when to buy insurance is from former hedge fund manager turned author Lars Kroijer, an occasional contributor to Monevator. His most recent book, Investing Demystified
Most people buy far too much insurance. In this article I will explain why I believe you should only buy insurance when you really can’t afford the loss.
To understand my way of thinking, we will have to look at insurance from a different perspective – that of the business model of an insurance company.
“Come off it Lars. The only thing more boring than insurance is the inner workings of an insurance company…”
Stay with me! You might just save a lot of money over your lifetime.
How insurance works
Let’s start with the basics. The world of insurance can be divided into life and non-life insurance.
We’ll consider non-life insurance as an illustration.
Non-life insurance is for things such as your phone, car, house, travel, and other non-life things.
You might pay £500 to insure a £10,000 car against, for example, theft. In simple terms, the probability of making a claim against the full value of the car in any one year has to be 5%.1 Without necessarily thinking about it in those terms, most buyers of insurance probably consider 5% about right and therefore they believe that taking out the insurance is worth it.
But I do not think this is a good deal.
The reason I would not buy £500 insurance on my £10,000 car – other than the third-party insurance required by law – is down to my knowledge of the insurance company’s combined ratio.
The combined ratio is the sum of the claims and expense ratio.
- The claims ratio is exactly that – what the company pays out in claims to people whose cars were stolen or damaged, out of the pot of money it collects in premiums from customers.
- The expense ratio is all the other costs of the insurance company – marketing, administration, overhead, and so on.
Some types of insurance companies can have combined ratios over 100%. If customer’s claims don’t come due for a while, then the insurers can earn an interest on the premiums they’ve already collected until the claim falls due.
Earning money by investing this ‘float’ of premiums explains how insurance companies can be profitable, even when they write unprofitable insurance and so sport an overall combined ratio of greater than 100%.
However car insurance is usually a one-year policy, and insurance companies select assets that match their liabilities. Car insurance premiums are therefore invested in short-term securities that pay a low return. There’s no 20-year float for the insurance company to invest for long-term profits here.
Therefore the combined ratio for any car insurance policy needs to be below 100% for it to make a profit for the insurance company.
Car insurance is fairly predictable (compared to say insuring against hurricanes or terrorists) and the insurance company is likely to have a good idea of the total number of claims and expenses it will face in any particular year.
My research has found that a non-life insurance company might expect to have a combined ratio of 95% for car insurance policies, made up of a 70% claims ratio and 25% expense ratio. (My friends in insurance will bemoan this simplification, but we only need the rough figures to illustrate the point).
This means that if you are an average risk customer, every time you pay £100 in premiums for your car insurance:
You get £70 back in claims
It costs £25 for the insurance company to make it all happen
The company earns a £5 profit
In other words, you pay £30 for peace of mind for every £100 of insurance you buy.
Obviously you don’t get £70 back every year. In fact most of the time you get nothing back, because you don’t make a claim.
But when misfortune strikes, you get your £10,000 back.
Insure your car yourself
The point is that on average over a lifetime of buying insurance you would get £70 back for every £100 you spend on insurance.
That’s what the company’s combined ratio numbers tell us.
So the reason I don’t buy car insurance is that I don’t want to pay a guaranteed 30% to the insurance company (25% expenses plus 5% profit) if I think that over my lifetime I can afford to cover any potential losses myself when they arise.
Obviously it would stink to have my car stolen or damaged to the tune of the full £10,000.
However I see this as a risk I can afford to bear, not something I need to pay to protect against in advance.
Note: I do not think that I save the full £500 in annual car insurance. I think that I save the 30% difference between what I would have paid and the average claims that are made. I presume in my lifetime that I will have average luck, and eventually be faced with, for example, a £10,000 hit to replace my stolen car.
In my view the insurance company knows at least as much about my risk as buyer of insurance as I do. If it sets the average payout for me at 70% of a £500 policy then that is probably about right.
On average, over all the non-life insurance policies I don’t buy, I would expect to have a loss of £350 (70% of £500) on every £10,000 of ‘not insured stuff’ I own in any one year, and to have saved £150 by not buying insurance (30% of £500) to cover it.
The benefits of avoiding the insurance industry
It’s very important to realise that not buying insurance against things that we can afford to replace or have happen does not mean we think those things won’t happen.
It just means that instead of the bleed of constantly paying out small premiums to cover lots of things, we will instead expect to occasionally pay out larger sums when something does go wrong to replace those things we did not insure.
In the meantime, the money we would have been spent on insurance can be put into an emergency fund. There it can earn a return, and perhaps further reduce the financial impact of things going wrong.
Personally I also think the whole hassle of keeping track of insurance policies is a pain I would rather avoid.
I also seem to constantly hear stories about insurance companies that either fight claims or make claiming on a policy a huge headache.
Avoiding all this grief is an intangible benefit of not buying insurance.
Saving money on insurance can add up
Without being too scientific about it, adding up all the insurance I don’t buy – including life insurance – I personally save about £500 per year in expense ratio and insurance company profit by taking on the risks myself, instead of paying an insurance company.
Let’s assume I pocket this £500 saving every year for the next 30 years and invest it in the broader equity markets. If I generate a 5% real return on that money, my savings from not buying insurance over the three decades will amount to around £35,000 in today’s terms.
This is money that I have will then have, instead of it being in the insurance company’s pockets in 30 year’s time.
Remember, I am not assuming that I do not have accidents or that my car is never stolen in order to generate this £35,000.
I assume I’m at risk of those things exactly with the same probability that the insurance companies assume.
I pay for those unfortunate outcomes out of my own pocket – but I am still left well ahead.
When you should buy insurance
Investment advice typically has an “always seek expert advice” or “don’t try this at home” disclaimer attached.
Well, this time it really applies. Do not follow me blindly and cancel all your insurance policies tomorrow!
You should not save on insurance premium payments where you cannot afford the loss – and everyone is different in terms of what we can afford to lose.
- Very few people could afford to lose their house in a fire, so they should always insure against this possibility.
- Most people in countries without a national health service could not afford bad health situations and so should get health insurance – but it’s more finely balanced in the UK, where taxpayers already have the NHS.
- Perhaps you personally can’t afford to have bad things happen to your car. If that case, you should insure against theft and damage, regardless of the fact that I don’t. Same deal with the potential theft of the contents of your home.
But most people can afford to lose their mobile phone, to cancel a flight or vacation, or to shoulder an increase in the price of their electricity bill. So I believe they should not insure against those things.
Over time having no insurance should save you quite a bit of money, and that should make you sleep better at night.
Perhaps you will also look after that mobile phone just a little bit more because it is not insured, which in turn will lower the risk that you inadvertently lose it.
What about life insurance?
There are many instances where life insurance makes sense.
If you are in a situation where your death or disability will cause unbearable financial stress on your descendants, then the premium you pay on these policies is worthwhile.
As with the example of car insurance, you should take out life insurance when you or your descendants can’t afford the loss.
Whether they can or not is obviously a highly individual thing, but bear in mind there is a tangible financial cost to that intangible peace of mind from insurance that many people cherish.
Insurance is expensive. Make sure it is worth it.
Lars Kroijer’s Investing Demystified
- If there was exactly 5% chance of receiving a £10,000 payment then that chance is worth £500. So if you pay £500 for say a 3% chance of claiming £10,000 then you’ve made a bad bet, whereas if that risk was 7% then paying £500 for it would be a good bet (your expected value would be 7% of £10,000 = £700). [↩]
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While the premise is decent enough, you could have told him that Car insurance is a legal requirement in the UK, thus it isn’t really something that is ideal to focus the main point of the article on.
Lars,
Spot on……I am always telling my nearest and dearest to only insure against overwhelming loss.
In fact the probabilities of loss are lower than your illustration due to rampant insurance fraud. If the claims ratio is 70% but a significant proportion of the claims are fraudulent then the claims ratio for honest punters is less than 70%……maybe nearer 50% and that is then the true probability of a genuine claim being needed. The honest punter has to carry the expense ratio, the insurance co profit and the cost of the fraudulent pay-outs too.
Nice posting.
From the other side of the coin, I’ve often thought that providing insurance is the second best business model ever invented. The best being running a lottery. I would dearly love to run a lottery, but its illegal unfortunately.
Great point. I think this is particularly true for ‘casual insurance’ (e.g. mobile phone, bike, some forms of travel insurance). You can inadvertently end up providing coverage for people that take less care of their belongings because they have insurance.
I would much rather take the (limited) risk and invest the premium.
The loss ratio will be a lot higher than 70 per cent. on motor. Most of the money they make on motor won’t be on underwriting anyway, but on peripherals like car hire, legal expenses insurance, referral fees (where allowed) so it can run much higher.
You’ll probably find too that 3rd party only cover is more expensive than fully comprehensive as the risk profile of those who seek it is generally much higher and the premiums loaded accordingly. So, while the theory is good, achieving the benefits the author argues for (in motor if not the others) is difficult practically.
Some nice points here. I’ve been a big fan of Third Party only car insurance (i.e. the minimum legal requirement) for a long time now. Of course you can reduce the chances of theft to virtually nil by driving a cheap, undesirable car which helps reduce the risk of loss further.
Good post Lars and something I’m already on board with. Only get insurance when:
1) You’re higher risk than the insurance company thinks (this is rare, they tend to do their homework)
2) For losses you can’t afford (as you mentioned)
The key problem for me is that insurance is often all or nothing. Comprehensive car insurance is often, counter-intuitively, cheaper than 3rd party. And whilst I could afford to lose a TV or laptop, I would struggle if everything in my house was stolen or burnt down. The solution should be contents insurance with a high excess, but many places won’t go higher than £500.
Absolutely spot on, I follow this philosophy. One exception is car insurance, which in the UK is compulsory, and the price difference between 3rd-party-only and comprehensive is either negligible or reversed (i.e. 3rd-party-only is more expensive) — I think the reasoning is that someone who wants 3rd-party-only insurance won’t take good care of their car, and are therefore a higher risk.
Very good article. There seem so many different types of insurance just designed to give a feeling of security when there was no need to worry in the first place. My pet hate at the moment is gap insurance, only pay out IF you have an accident and IF your new car is written off. Chances of that for a new car seem pretty slim to me and I’d always assume a car depreciates anyway.
Good article, I have just come around to deciding to ditch fully comprehensive car insurance in favour of the legal minimum, so I’m disappointed to hear from other posters that it might not save much money.
One of the barriers to buying insurance sensibly is that often its not possible to insure only against catastrophic loss.
Regarding health insurance in the UK. If you have a health catastrophe of an acute nature, this is generally excluded from private health insurance so you will end up in the NHS anyway.
p.s. its a better pic. I agreed with the other poster but was too polite to say so…
Great post and I am broadly inline with sentiments in comments. A few points though
– you do have to be quite rich to have the kind of capital that can replace a modest car (most 20-3o year-olds would struggle I would guess)
– we are human and not fully rational so the peace of mind that insurance buys might be a sensible investment in psychological health (financial losses are disproportionately traumatic)
– insurers can buy from contractors in bulk. The insurance company will get a much better deal on car body work than an individual would.
Despite the points above I only buy tail risk insurance with the highest possible excess when I can. (Car hire excess – waiver insurance and warranties on electrical goods are the biggest rip-offs worth avoiding in my book)
This is not rocket science – all those clerks, salesmen and women, managers, agents, call centres, loss adjustors, claim processors, even postmen and women are paid for out of the excess charged by insurance companies over what they pay out. Then there’s all the false claims which we pay for, and the cost of the efforts to stop false claims all come from our premiums.
By the way – why is Life Insurance not called Death Insurance? Insurance that would really interest me is actual Life Insurance that will pay out if for example I am alive at age of 90. Does such a product exist (in UK)? Any information welcome!
@PaulM. Isn’t that an annuity? 😉
@PassiveInvestor
If you can’t afford to replace your car out of your savings then you’ve spent over 50% of your net worth on buying a vehicle (a depreciating asset), which means you should probably have either bought a cheaper one or managed without until you had a bit more capital.
Either that or you’ve borrowed money to acquire a car of luxuriousness way beyond your means, which is just plain financial stupidity.
And don’t get me started on pet insurance!!!!
many thanks for the comments. One thing I forgot to mention was that even in the case where you buy insurance (so in instances where you can’t afford the loss) you can still mitigate the high cost of the insurance by maximizing the deductible (or first loss). This makes sense because you insure a lower amount, but I also wonder if the insurance companies don’t take your willingness to take part of the risk as a signal that you are lower than average risk and thus lower the premium as a result? I don’t have any data to substantiate that last point though – purely guesswork.
I hope to write a piece on annuities soon (there is a section in my second book about annuities). I generally think they are crazy expensive too and walk through the math of that. But again there are cases where they make sense for some people.
@BeatTheSeasons:-my wife has a pedigree cat. I hate cats (selfish brutes), but when the stupid creature managed to get run over by a car we ended up with a vet’s bill of over £15k!
Now, I would have said- put it to sleep, and the trauma this would have caused doesn’t really bear thinking about. But she had taken out pet insurance.
The moral to this is that pet insurance saved me from divorce.
I bet you didn’t factor the opportunity cost of this eh. Lars?☺
@Borderer
Stories like yours do go to show that calculating expected values is a little flawed in that it glosses over outlying chance events, which statistically speaking are bound to happen to someone. Imagine if you had written off your car the same week but only had third party insurance!
On the other hand, our dog developed a serious injury that was going to cost thousands of pounds and involve overnight stays, MRI scans and operations….. right up until the point that the vet discovered we had recently cancelled our pet insurance. The treatment ended up costing a few hundred pounds and the animal made a miraculous recovery.
Lars, your maths is wrong. The maximum value of an insurance claims on your £10,000 car isn’t £10,000. It’s in the millions — the reason is that if you hit a third party, say a young, high-earning man with a family, and injure him such that he requires medical care for the rest of his life, you’re on the hook for his medical bills and all his lost earning power.
I work for an insurance company and have seen these sorts of claims, and they often have a bill reaching into the seven figures. This is the reason why car insurance is compulsory — so that the guy you injure can get medical care regardless of whether or not you, as the driver who caused it, is able to pay the bill.
@everyone — Lars’ article says and has always said third party insurance is compulsory.
@Andy, you beat me to it. Third party liability is the important reason for it being compulsory.
I think the same applies to other situations where claims could amount to millions such as employer liability etc.
PPI and similar are probably extreme examples of insurance that is a waste of time. Bet that would factor well on the calculations for claim ratios when most people can’t make a claim on it! Insurance companies seem to prey on insecurities and emphasise how the impact of needing a claim rather than the likelihood (unsurprisingly as it benefits them)
We all need to think logically about how often/likely a claim is to happen vs how much it would cost to fix. As above GAP insurance is one that seems to be a winner for insurance companies as does home breakdown cover – look how profitable Homeserve are for example.
I suspect one reason a lot of people buy insurance is the very real emotion of loss aversion. People may know that the insurance has a negative expected return but prefer paying out small amounts over a long period of time rather than losing a large amount all at once.
@Strike3
O yes – an annuity is another insurance company way of paying all those people some of your money!
But ‘life insurance’ that pays out if I survive to 90 years old is quite different from an annuity. I pay premiums now and get a lump sum later. So actually sort of the opposite of an annuity.
@The Investor — agreed. I pointed it out because it was used throughout the article as the prime example, yet (in my experience anyway) there is so little difference between 3rd-party and comprehensive that there is no logical reason for choosing 3rd-party-only.
What wasn’t mentioned (or I missed it) is the “insurance for the insurance” that they increasingly want to tack on, like “protecting your no-claims bonus”, “protecting your premium”, “protection so that you don’t have to pay a deductible”, and the list goes on. And the way the telephone agents word everything is in a very tut-tut way, blatantly implying that you are making a very serious mistake by not paying for all these extras (“are you sure sir, it is only an extra £22 a month, if you don’t take it out I can virtually guarantee that you will regret it”). I find this particularly egregious, and I always leave those phone calls fuming; thankfully it is only once a year that I have to endure it.
@passiveinvestor
I would suggest you can’t afford to run a car then, or you are buying too much car for your financial position. I bought my first car on a loan, and immediately started saving for the next one after discharging the loan. It’s worked for me since I was 26, and means on average you’re carrying half the replacement value. Cars are much cheaper now in real terms than they were a couple of decades ago too.
One thing I’ve noticed is third-party fire and theft was cheaper up to when I was about 40, then there wasn’t much in it and now it can be dearer.
I always go for a high deductible for exactly Lars’ reason, though at the moment I have been carrying a £400 excess due to some drunken prat who hit me on my side of the road, he’s been done in court for it but the insurance companies are stringing it out – ever since February 2013. The other side was even cheeky enough to offer to split responsibility – after he’d been convicted!
So if you do go for a high deductible, be open to carrying the loss for a couple of years 😉 I don’t need this £400 and couldn’t turn much of a return on it over the last year and a half but it does show the hazards.
@ermine. Would that suggest that you couldn’t afford to buy your first car 😉
Dammit! I meant:
I completely agree with the point of the article, although as others have pointed out it is in practice sensible to buy comprehensive car insurance, albeit with the highest excess.
I don’t always have the time, but when I do, I really enjoy explaining the point made in the article to zealous insurance salespeople who really are convinced that they are on a mission from God to save me from all kinds of minor financial losses. I usually start by pointing out that “only £2.50 per week” is actually £1200 over the next 10 years, and then dissect the likelihood of actually making a claim over the next 10 years. They never have an answer to this, and they just quietly thank me for my time and end the call. None of them ever shown any signs of having thought about the point before.
I’d like to think that perhaps just occasionally the salesperson thinks over these points over the next few days and, realising that they are unknowingly making their living by persuading people to waste their money, resign. (“You may say I’m a dreamer, but I’m not the only one…”)
One other factor which makes Lars’ point even more true is that I’m convinced that I am a more careful person than the average and I would guess that most monevator readers are too. I have been driving for decades and have not yet caused an accident, though of course this could just be luck. Nor have I ever lost my mobile phone. Nor do I ever run up any credit card debt that I could not pay off immediately if it were not for the fact that I’m quite happy to have a few weeks of free credit.
If these points were better understood, then there would be a real market for insurance that just covered huge losses only. For instance, in travel insurance I do want to be covered for the remote possibility that I might need to be repatriated by air ambulance, because this would cost a fortune. I have no interest whatsoever in being covered for, say, my suitcase going missing, because I can replace its contents for a few thousand pounds.
Perversely, it is often these small risk/big cost eventualities that are excluded from cover, such as many health insurance policies that do not cover you for cancer treatment. I’m not particularly interested in having cover for going to see a specialist because this only costs a few hundred pounds, so I’ll pay this if I need to. I would rather buy cover just against something like cancer treatment, which could cost, say, £50,000.
@Jonny
Absolutely. I was working in London for the BBC in White City and lived in Ealing. And commuted by bicycle along the Westway/Western Avenue because it was a devil to park at Television Centre. Buying a car was a stupid thing to do, I sometimes had to park the damn thing 100 yards away from my bedsit.
Show me the 20-something who doesn’t make mistakes and I’ll show you someone old before his time. But I did learn from that – the start saving as soon as you buy a car for the next one served me well until those savings became a smallish part of the emergency fund. The policy was put in place as soon as I discharged the loan because I realised I had just paid about £110 for every £100 worth of goods. I spent £7500 in today’s money on that car – I’ve never spent as much is real terms on a car ever, though the dramatic fall in the cost of cars and the improvement of quality helped.
I very much agree with the point of using insurance as a way to eliminate/limit highly unlikely/catastrophic outcomes (what I in the blog call outcomes you can’t afford), and wish there were more products tailored towards this specific issue – in finance you’d call this tail risk. The insurance companies reinsure against it.
Chuckled at the comments on pet insurance. My wife wanted to insure our golden retriever a couple of years ago and I her gave the whole speech about insurance being a bad deal. The poor dog has gone on to cost us a fortune since then.
One last point/question. A friend suggested that it could actually be economical to buy insurance against some kinds of consumer goods. Imagine you insure breaking/losing your Ipad. Instead of risking that you as an uninsured customer buy a competing product when you break/lose your Ipad at some point in the future, Apple may actually give you a huge effective discount on your next Ipad via cheap insurance. So if you know for sure that you would have replaced your broken/lost Ipad with another Ipad in the future it may be economical to buy insurance on it in the first place (even assuming that you are only as likely to break/lose it as the insurance company expects). To know the answer to this you would have to know a lot about expected loss ratios, Apple discounts, upgrades, etc., but I think it is an interesting, if slightly far fetched argument. If anyone from consumer product space knows an answer I would love to hear about it.
@ermine
My tongue was firmly in my cheek when I posted 😉 The start of the second sentence just seemed to be too much of a contrast to the first, for me not to comment.
I *nearly* took out a 5 year loan for my first car in my late teens/early twenties, but was fortunate enough to be offered a decent (reliable that is, not flash) car for a quarter of the price (for which I paid cash).
I remember thinking 5 years on how glad I was that I wasn’t still making payment, on what wasn’t even a particularly fancy car (a Peugeot 106 in fact 😉 ).
This had got me musing about cars and insurance. I have to say its only been recently as I built up more savings that I’ve realised I am comfortable exposing myself to the full cost of replacing a car. Does that mean I was buying more car than I could afford? I don’t think so. I’ve always bought cars for cash, and then built up savings again for the next one. Of the seven cars I’ve owned (in 25 years) three have been replaced on insurance – one theft, two accidents (one at fault). The last decade has been clean though 😉
Ok not that anyone but me is interested, but that first car was worth £1500 in today’s money, and was financed from a small inheritance while I was a final year student. If I hadn’t had that I’d have used my student overdraft, as I would have struggled to travel to my final year placements without it. Most recent purchase cost £8000 six years ago…I only just twigged how much I’m overpaying for my insurance now that it’s only worth a few grand (and yes, I’m stupidly protecting a no claims bonus!)
God, these extravagant rich kids who bought a car at twenty. Motor bike for me. Bought for cash. A motor bike can also save you from a lifetime of buying insurance.
My mum wouldn’t let me buy a motorbike. In fact I still don’t think she would now!
@dearieme — Very droll. 😉
@Vanguard fan… 7 cars in 25 years. Wow. That’s a lot of cars. I think i’m too lazy to get involved with that much paperwork!
Well, I only actually chose to part with three of them!
Mind you, I’ve only had 3 bikes in 34 years…an important difference being they still only need to transport me, rather than an expanding family!
Yup, minimise insurance premiums and only insure against catastrophic loss. The flipside is having some insurance company shares in your portfolio, a very solid business that has served me well over the years.
You want a life insurance that rewards you for living? These were (are) called “endowment assurances” and we here in the UK remember the problems that the so-called “low-cost” version caused in the mortgage market.
My advice would be “buy term and invest the difference”.