The 10 Smartest Things Ever Said About Insurance

Insurance is defined as “A financial risk management tool in which the insured transfers the risk of potential financial loss to the insurance company…in exchange for monetary compensation known as the premium.” 

Nobel Prize winner Daniel Kahneman sums up the purpose of insurance by stating that it can be thought of as “a choice between a sure loss and the risk of a greater loss.”  The sure loss (the premium) is small, certain, and is paid regularly.  The potential greater loss is large and its timing, magnitude, and occurrence are all unknown. Insurance provides price certainty and eliminates the possibility of the larger loss, but there is a cost. 

Insurance is an important part of any financial plan but it is both impossible and unwise to insure against all risks.  So to help you decide what risks to insure against and which to face on your own, here are the 10 smartest things ever said about insurance:

 (1)  Protect against Catastrophes: “If I had my way, I would write the word ‘insure’ upon the blotting book of every person, because I am convinced that for sacrifices that are inconceivably small, families can be secured against catastrophes which would otherwise smash them up forever.  Winston Churchill

The proper use of insurance is to protect you from catastrophes that could “smash you up forever.”  Take a few minutes to consider what these are for your family and then make sure you are adequately protected against them.

(2)  Offense and Defense: “…don’t insure yourself to the point that you spend so much in premiums you have no other investment options available.  Insurance can help make sure you don’t ‘lose’ but insurance will never help you ‘win.’”  Scott Ford   

This just in from the contradictory clichés department:

  • Defense wins championships, and
  • The best defense is a good offense

So which is true?  In the world of money, both.  You need to play defense to protect what you have, but if you expend too many of your resources on defense (insurance) you won’t have enough left for a strong offense (investing).  Successful money management requires a balance.

(3)  Insurance and Probability: “It is important to understand that the [expected] return from buying insurance is always negative.  That is, you can’t make money “on average’ and the insurance company make money “on average” at the same time.  Instead, they charge you – and everyone else – more than the amount they expect to pay out.  Otherwise the company would go bankrupt, and you wouldn’t get paid either.”  Moshe Milevsky      

Insurance companies are businesses, not charities.  Their goal is to make money and they hire a lot of very smart people called actuaries to make sure they do.  Therefore, every time you buy insurance the odds of the transaction paying off for you financially are negative. 

This doesn’t mean you should never buy insurance.  After all, the primary purpose of insurance is to protect you against major disasters, not to make money.  Your hope is that you will never need the insurance.  It does mean that you should limit your use of insurance to protection against major catastrophes and not use it to protect yourself from life’s minor risks.      

(4)  Guiding Principle: Here’s my guiding principle [for deciding whether or not to insure]: Catastrophic and Unlikely.  Moshe Milevsky

Given what we have learned so far, Milevsky’s Guiding Principle of using insurance only to protect against risks that are both catastrophic and unlikely makes perfect sense.  Let’s look at life’s risks in a little more detail.  As the chart below shows, all financial risks can be placed in one of four categories.

 

11-11-16_insurance-risk-matrix

 

Let’s take a closer look at the categories:

  • Likely Small Losses: Welcome to life. You don’t know exactly how or when these losses will happen, but you do know they will happen.  Include some leeway in your budget to cover this type of loss.
  • Likely Catastrophic Losses: Insurance for this type of loss is probably too expensive to purchase. Your best option is to do everything you can to lower the risk. 
  • Unlikely Small Losses: Insurance for this type of loss is almost always a bad deal. Your best bet is to self-insure against this type of loss through an emergency fund or a self-insurance fund.  Extended warranties fall under this category. 
  • Unlikely Catastrophic Losses: These are the types of potential losses where insurance makes sense. Losing your automobile, home, health, and life are the most common unlikely catastrophic losses most people face.  Therefore, at a minimum, most people should have automobile insurance (if you own a car), homeowner’s or renter’s insurance, health insurance, and life insurance (if others depend on your income).    

(5)  Insurance Risk Policy: “Decision makers who are prone to narrow framing construct a preference every time they face a risky choice.  They would do better by having a risk policy they routinely apply whenever a relevant problem arises.  Familiar examples of risk policies are ‘always take the highest possible deductible when purchasing insurance’ and ‘never buy extended warranties.’  A risk policy is a broad frame.  In the insurance examples, you expect the occasional loss of the entire deductible, or the occasional 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.  Daniel Kahneman

Mathematically, the best insurance “on average” is always self-insurance.  That is why applying the risk policies suggested by Kahneman “will almost certainly be financially advantageous over the long run.”  It is impossible for most of us to self-insure against major catastrophes, so insurance is needed.  The key to putting the insurance odds in our favor is to increase the risks we self-insure against as we become financially able to do so.      

I would caution against always taking the highest deductible offered by the insurance company and modify the suggested rule to state “always take the highest deductible possible given your current financial situation.”  In other words, take the highest deductible that would not be catastrophic to you.

As for extended warranties, if replacing the new large-screen TV you just purchased without an extended warranty would be catastrophic to you, you need to consider the possibility that you shouldn’t be buying a large-screen TV.         

Under Milevsky’s Guiding Principle of only using insurance to protect against risks that are both Catastrophic and Unlikely, we can now add a couple of specific rules:

  • Always take the highest deductible that would not be catastrophic to you
  • Never buy extended warranties

(6) Create Your Own Self-Insurance Company: In his book Your Money Milestones: A Guide to Making the Most Important Financial Decisions of Your Life, Moshe Milevsky suggests creating a “Small Risks” fund to protect yourself from unlikely small risks.  When you raise your deductible on your auto insurance, put the amount you save every month in this account.  When you resist the aggressive sales pitch to purchase an extended warranty (there is a reason retailers push extended warranties so hard, and it’s not because they are a great deal for you) transfer the amount the warranty would have cost to this account.  Then, when the unlikely happens, you are prepared. 

I like to think of this account as my own self-insurance company.  Being self-insured against certain risks doesn’t mean simply forgoing insurance coverage and allowing what you save to disappear into the black hole of your monthly spending.  It means saving the difference in an account dedicated to covering the type of risks you are no longer insured against.  Remember, insurance always has a negative expected return.  Starting your own self-insurance company is a great way to put the insurance odds in your favor, but you need to actually save the money you are saving by not purchasing insurance.

(7) Life Insurance Rule of Thumb: “There is a simple rule of thumb to determine whether you need insurance: If someone depends on you economically, you need life insurance.”  Carl Richards

And if no one is depending on you economically you don’t need life insurance.  It really is that simple.

(8)  Don’t Gamble with the Security of Your Family: “Not to insure adequately through life insurance is to gamble with the greatest economic risk confronting man.  If understood, the gamble is a particularly selfish one, since the blow, in the event the gamble is lost, falls upon an innocent household whose economic welfare should have been the family head’s first consideration…Failure to safeguard dependents is little short of a crime.  Solomon S. Huebner   

Insurance against the death of someone who provides a significant portion of a family’s income is perhaps the clearest example of an unlikely but catastrophic event that should be insured against.  In addition, the insurance to protect against this type of risk is generally very affordable.  There are few valid excuses for not protecting your family with adequate life insurance. 

(9)  Don’t Mix Insurance and Investments:  “Life insurance is one of the simplest parts of the financial plan that is made the most complex.  Don’t let it be.  Invest with investments and insure with insurance.”  Jim Stovall and Tim Maurer

The complexity of financial instruments rarely, if ever, works in the favor of the individual purchasing them.  This is definitely true for life insurance.  Term life insurance is much cheaper than the more complicated varieties of insurance that mix insurance and investing.  Carl Richards, as he so often does, captures this truth in one simple drawing:

 

variable-life_carl-richards

 

Don’t mix insurance and investments.  Stick with term life insurance and invest the money you save.  When it comes to life insurance, simplicity is the key.

(10) The 20-20 Plan: “Call it the 20-20 plan.  All you have to remember is 20-20.  Set aside 10 minutes, multiply your salary by 20 and buy a 20-year term policy in that amount.  Cross this item off your list and stop losing sleep over life insurance.”  Carl Richards

This is brilliant.  Many of us put off purchasing life insurance because we think it will be complicated.  Richards reminds us how simple it should be.  Don’t worry about it.  Don’t overthink it.  Just do it! 

 

There you have it.  The 10 smartest things ever said about insurance.  Let these ideas be your guide as you implement an insurance plan to protect yourself from the worst financial consequences of catastrophes while still leaving you the resources to play a little financial offense.  You have the knowledge.  Now it’s time for action!               

 

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