Money is a Game of Probability: Guidelines for Buying Insurance

I recently wrote about “The Four Laws of Success and Probability.” The third law states, “If…the odds are not in your favor, avoid the game – if it is impossible to avoid the game, play with great caution.”

Insurance is a game where the odds are never in your favor. The expected value of any transaction you make with the insurance industry will always be negative. Insurance companies pay very smart people called actuaries a lot of money to make sure this is true. If the insurance companies are wrong very often they won’t stay in business.

Even though the odds are never in your favor when you buy insurance, it would be extremely reckless to avoid insurance in all instances. After all, improbable disasters happen all the time, and you are not exempt. Therefore, you should play the insurance game only when necessary, and with great caution, but you do need to play.

Here are a couple of guidelines to help you get the most out of your dealings with the insurance industry:

• Insure only against risks that are financially catastrophic and improbable
• Make insurance companies compete for your business

Financially Catastrophic and Improbable

Why should we only insure against risks that are financially catastrophic and improbable? If a future event would be financially catastrophic, but it is not improbable, insurance will probably be too expensive to afford. Insurance companies aren’t stupid, and they will charge a high enough premium in these instances to put the odds in their favor. Your best bet is to take any steps you can to reduce the probability of the event. At that point, insurance might make sense.

If a future event would not be financially catastrophic, and it is unlikely to happen, you don’t need to ensure against it. Life is full of risks and we cannot possibly ensure against all of them. Save enough in an emergency fund to cover small financial setbacks and live your life without worry.

In cases where a risk is both financially catastrophic and improbable insuring against the risk is a wise choice. While these guidelines seem like common sense, I am amazed by how often people don’t follow them. Here are some example of how these guidelines apply to several of the more common types of insurance:

• Life Insurance – If people are depending on you financially, and it would be catastrophic for them if you were no longer able to provide support, you need life insurance. You don’t need life insurance on your children. It would be catastrophic to lose one of them, but not financially catastrophic. Term life insurance is the only type I recommend. It is simple, reasonably priced, and protects those you love against the loss of your financial support.
• Health Insurance – It’s now the law to have health insurance, but it is also prudent. My wife, Alice, is just finishing up treatment for breast cancer. We caught it fairly early, and I am happy to report that the outlook for her is great, but the total bill will come to several hundred thousand dollars. It would definitely have been catastrophic for us financially if she were not insured, and during a health crisis there are more important things to focus on and worry about than money.  
• Auto Insurance – It’s the law to have liability coverage, and also prudent. Causing a serious accident without insurance could definitely be disastrous financially. As for collision and comprehensive coverage, it depends on how much your car is worth and how much of a financial hit would be catastrophic for you. At the very least, if you have a good emergency fund consider raising your deductible.
• Extended Warranties – Did you ever wonder how come stores try so hard to sell you extended warranties? It’s because they often make more money on the warranty than on the sale of their product, which means the odds of you benefiting from the transaction are very low. Furthermore, if replacing the TV or computer you just bought would be catastrophic for you financially you probably shouldn’t be buying it anyway. Avoid purchasing extended warranties and concentrate on an emergency fund to cover life’s little mishaps instead.    

Make Insurance Companies Compete for Your Business

In the late 1990s prices on term life insurance starting dropping dramatically. At first no one could figure out why. The risks for insurance companies hadn’t changed and there weren’t any other obvious reasons for the drop in prices.

It was only later that the reason for the better deals became clear. About this time the first websites offering quotes from multiple insurance companies were born and term life insurance was their first product. The competition forced companies to lower their prices.

When you buy insurance it is a transaction between unequals. The insurance companies have infinitely more knowledge and data than you. You really have no way of knowing whether you are getting a fair price or not. Competition evens the playing field and keeps the insurance companies honest.

Making insurance companies compete for your business is the best weapon you have to ensure you get a fair price and the internet makes your job of promoting competition quick and easy. A website I have used for this in the past is www.selectquote.com. In addition to term life insurance they also provide quotes on auto and homeowners insurance. Whether you use this website or another one don’t buy insurance without using competition to help you get a fair price.

Insuring only against risks that are financially catastrophic and improbable will limit your use of insurance to only those instances when buying it is prudent, and using competition when you do buy insurance will guarantee you get a fair price. Learning and using these two simple guidelines will help you make wise decisions as you navigate the world of insurance.