I recently started my own self-insurance “company”. Here are some details about my new company.
- Startup Costs: $0
- Startup Time: 30 minutes
- Business Purpose: Take on an increased, although still small, part of the risk of driving a car, owning a home, and purchasing appliances and electronic equipment.
- Revenue: Modest but steady. Right now my revenue is $50 per month but this will increase as I take on more risk.
- Expenses: Unknown. Based on my family’s driving abilities, the laws of probability, and good old-fashioned luck.
- Future Prospects: Unlike most businesses, which fail in their first few years, the odds are favorable that my self-insurance company will survive for the long term and make a modest profit most years.
Insurance and Regret
From a purely economic standpoint, insurance doesn’t make sense. Every time you purchase insurance you are entering into a gamble with an expected negative value. Insurance companies pay a lot of very smart people called actuaries a lot of money to ensure this is true. Insurance companies are not charities whose goal is to protect you from unexpected disasters but businesses designed to make money.
And yet insurance companies have thrived for thousands, of years. This made no sense to economists whose entire profession is built on the theory that people are rationale and act in their own best interest. If people are rationale why do so many willingly enter into insurance contracts with negative expected values? This was the paradox facing economists.
The answer came not from an economist, but from Noble Prize winning psychologist Daniel Kahneman. Kahneman correctly identified the decision to purchase insurance not as a purely economic decision, but an emotional one as well, and the emotion pushing people to buy insurance was regret.
Not actual regret but “the anticipation of regret.” We imagine something bad happening in the future and further imagine our regret if we don’t act now to protect ourselves against this imagined future disaster. Regret is the reason insurance companies thrive.
Indeed, insurance premiums can be usefully thought of us regret premiums. We willingly pay the premium now, even though we know it doesn’t make sense from a purely economic standpoint, in order to avoid future regret.
This human desire to avoid regret can be both beneficial and harmful. It is beneficial when we use it to insure against catastrophes but harmful when we use it to insure against inconveniences. You should gladly go on paying insurance premiums to protect yourself against the type of disaster that, in the words of Winston Churchill, would “smash [you] up forever” but if you are paying insurance companies to protect you from life’s small emergencies you should stop immediately and start paying this regret premium to yourself. This is where your own self-insurance company comes into play.
Starting Your Own Self-Insurance Company
So how do you start your own self-insurance company? It really is simple. Here is how I did it.
- Establish an emergency fund – Before starting your self-insurance company make sure you have at least a small emergency fund. How much you have in this fund is up to you, but I suggest a minimum $1,000.
- Set up an online savings account dedicated to self-insurance – I use Capital One 360 for my online savings accounts because you can set up multiple accounts quickly and easily. Your regret premiums will be paid into this account.
- Raise the deductible on at least one insurance policy – I started by raising the deductible on my auto insurance from $500 to $1,000. If your deductible is $100 you might consider only raising it to $500 initially.
- Set up an automatic transfer of the monthly savings to your self-insurance company. Calculate what you save each month by raising the deductible and transfer this amount to your self-insurance account. An automatic transfer at the same time you pay the insurance premium works best.
As time goes on and you build up some money in your self-insurance account consider raising your deductible further. With auto insurance, if you drive an older vehicle it might be wise to cancel your collision coverage altogether. Money magazine suggests ditching your collision coverage if your car is more than 10 years old or worth less than 10 times what you pay annually for collision coverage. Also consider raising the deductibles on other policies such as your homeowner’s policy.
Extended warranties are a huge money-maker for insurance companies and the ultimate example of paying a steep price to avoid the regret, not of a catastrophe, but of an inconvenience. If you are in the habit of buying extended warranties stop immediately and start paying what you would have paid into your self-insurance account.
Kahneman suggests establishing a broad based risk policy rather than approaching each insurance decision in isolation. Two rules he suggests for a rationale risk policy are:
- “Always take the highest possible deductible when purchasing insurance.” and,
- “Never buy extended warranties.”
I would add a word of caution that the “highest possible deductible” is not the best choice for everyone. Instead, choose the highest deductible that would not be catastrophic for you.
Kahneman than adds, “…you expect the occasional loss of the entire deductible, or the failure of an uninsured product. The relevant issue is your ability to reduce or eliminate the pain of the occasional loss by the thought that the policy that left you exposed to it will almost certainly be financially advantageous over the long run.”
Kahneman is brilliant, and I hate to disagree with him, but I think for most of us the act of simply thinking that our temporary loss has been offset by prior gains would do little to minimize our regret. If we suffer a loss due to increasing a deductible or not buying a warranty we are going to feel the regret even if intellectually we know we shouldn’t.
Your self-insurance company solves this problem by creating a regret scoreboard. If you have several thousand dollars in your self-insurance account, and have to pay $1,000 out for a deductible on an auto accident, you will certainly regret causing the accident and having to pay the money, but you will not regret raising your deductible.
The money in your account is there just for that purpose and is concrete evidence that the decision to self-insure against this type of risk was a wise one. Paying a regret premium to yourself allows you to keep score in an incredibly compelling way that goes a long way to solving the problem of regret when you self-insure.
Float Your Boat
From the beginning Warren Buffett has loved investing in insurance companies and some experts see this as one of the keys to his incredible success. One of the things that intrigued Buffett about the insurance industry was the concept of float.
Float is the time difference between when premiums are received by insurance companies and when claims are paid out. During this time the premiums can be invested. Float from insurance companies allowed Buffett to have more money to invest than he otherwise would have had.
This same concept can be put to use by you, albeit on a much smaller scale. The regret premiums you pay into your self-insurance company can be invested until they are needed to pay out claims. I recommend keeping a couple thousand dollars in a simple, safe, and liquid savings account but if the money in your account grows larger than this feel free to invest it more aggressively.
While the money you pay yourself for self-insurance won’t be enough to make you rich, even if you are lucky in avoiding claims and successful in investing it, having extra money to invest can only be seen as a good thing. So take a hint from the world’s most successful investor and use insurance float to add to your available investing pool.
In conclusion, starting your own self-insurance company is a great way to use the insights of behavioral economics to benefit your bottom line. The very human need to avoid regret can help you make the wise decision to insure against potential catastrophes but it can work against you when you insure against small emergencies and inconveniences. Avoid this temptation by starting your own self-insurance company and paying a regret premium to yourself. It will almost certainly be a wise financial decision while at the same time allowing you to avoid the future regret of taking on increased risk.
Additional Reading: The 10 Smartest Things Ever Said About Insurance