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, makes the strong case for index funds.
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.
- 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). [↩]