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When Should You Self-Insure?

Some people have an affinity for insurance and buy all the coverage they can get. It gives them peace of mind, at a price. Others are suspicious of insurance and loathe paying premiums for services they may never use.

Count me in that latter camp. But, I’ve tried to be rational in evaluating our insurance options. For example, there was never any question of carrying life insurance while our son was growing up. But as soon as he, and we, had clearly reached financial independence, I cancelled my large life insurance policy. There was no point in paying those hefty premiums, once we were no longer dependent on my income from work. Same story with disability insurance. (Though I have kept some inexpensive accidental disability.)

The insurance industry has perfected its guilt pitch for life insurance: you are an irresponsible parent if you don’t have insurance in place to care for your children if you were gone. Probably true. Yet the industry has extended that guilt trip willy-nilly. You’re being reckless or thoughtless if you don’t buy every new insurance product it invents. (I suspect umbrella insurance may be in this category. It’s not terribly expensive, and it purports to protect our wealth from all manner of liability, so I carry it. But an insurance rep at a large company confided in me a few years back that she’d never heard of a claim being paid.)

Some insurance is clearly redundant. Why would you need payment protection insurance, for example, if you have decent life and disability coverage?

And beware that insurance doesn’t necessarily make covered problems disappear in a cloud of bliss. You still have paperwork, deductibles, copays, coinsurance, and time limits to contend with. And that assumes the insurance company accepts your claims. Most insurance is better understood as a way to defray costs. This is most evident to me with long term care policies — which usually pay only a portion of your expenses over prescribed time frames. They don’t typically guarantee that you will have no long term care expenses.

So the short answer to the question "When should you self-insure?" is “Whenever you can.” Remember that insurance is generally a business, run at a profit. That means that whenever you can reasonably self insure, you will also turn a profit. You’ll come out ahead in the long run.

But before you cancel all your policies, and put yourself or loved ones at risk, do ask yourself some tough questions:

  1. Will you be "in business" to pay a claim? This is why you can’t self-insure for life (or disability) insurance, at least not as long as you have dependents relying on you for income. If they need you to be alive and working to put bread on the table, then part of caring for them is buying enough insurance so they are not destitute should you pass from the scene. But there is still room for discretion in determining how much life insurance you should buy. The insurance industry has rules of thumb for why you should buy a lot. I think that’s a personal decision and depends in part of where your dependents are in life. If they are healthy, my opinion is that you should buy enough insurance to give them a generous cushion for transitioning their lives (or growing up), but not necessarily so much that they become independently wealthy by virtue of your exit.
  2. It’s not enough just to be “in business” (alive). Could you afford to pay a claim from your liquid assets? You’ve got to have the cash flow to make good, without taking losses elsewhere. That’s why most people can’t self-insure their home (even though the chances of losing a home to house fire are miniscule) or health care. However you can crank up those deductibles.

    And you might be able to self-insure your auto in some cases. Auto liability is required by law, so you don’t have to consider that option, but dropping auto collision coverage can be viable. To do that, you must keep $5,000-$10,000-$15,000, or whatever you think you’d need to pick up some reliable used transportation on short notice, available in an insured savings account or low-volatility investment. And I’ll guess that’s where most people get cold feet and decide to pay an insurance premium instead: it’s a lot of cash to part with all at once. Just be advised, you’re effectively making the same payment, over time, via an insurance premium. Which brings us to the next question.…

  3. How likely is a claim? Insurance companies have the data and the business volume to answer this question very precisely, and that’s why they can run highly profitable businesses under conditions where we, as individuals, cannot. Still, there are situations where we have pretty good data, possibly even an edge over the insurance company. You know your family health history. You know the individuals in your family and how they behave. For example, after my son had been driving a few years, I dropped the collision coverage on his 12-year old vehicle. I knew he was an excellent driver, and a quick back-of-the envelope calculation told me that it just wasn’t worth the premium we were paying to insure the current salvage value of that vehicle, given the low probability of an accident. We could self-insure.

    How does that math work? Well, here is a simple formula I learned for evaluating probabilistic problems in engineering school: premium = loss x probability. So if you’re putting a vehicle worth $5,000 at 5% risk of loss annually, a "break-even" premium would be about $250/year. Anything higher than that, and you’re better off self-insuring. (An actuary could provide a more sophisticated analysis, but I suspect this is close enough for our purposes.)

Self insuring can be scary, no doubt. Sometimes insurance feels cheap for the peace of mind conferred. For example, I’ve made some impulse insurance buys over the years related to major appliances. I generally abhor maintenance contracts and service plans, but, on a couple of occasions, when the appliance seemed expensive and the plan seemed cheap, I’ve gone for the bait. It’s always been a mistake. We’ve yet to collect: all our appliances have outlived their service contracts without major repairs.

Similarly, last year I was offered a service contract on our small RV. The plan was around $60/month and covered a litany of Murphy-esque problems for every major system on our rig. The glossy brochure was complete with stories from grateful travelers who had major repair bills paid, and their vacations saved from heartbreak. I nearly took the bait again. But then I looked at the hefty deductible, and the low probability of most of the failures, and realized I’d make a profit if I self-insured. At this point, I’ve already saved more than $800 by not buying that policy — enough to pay for the first major repair, should it materialize.

I’ll admit there is one area where I’ve always found it easy to justify a service contract: my computers. Access to a functioning computer has been critical to my livelihood ever since the start of my career. Being down, even for a few hours, is guaranteed to produce frustration, and possibly even loss of income. I’ve never had a problem paying a few hundred dollars annually to avoid that. Since computers were my profession, I had a good feel for the costs and benefits. And, I’ve exercised those computer service contracts a number of times over the years.

Insuring my computers is essentially a business decision. Ideally, you should evaluate all insurance unemotionally, with the same cold look at the financial facts you’d use for running a business. Neutralize the sales pitch. Ask yourself the tough questions. And make a rational choice.…

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Comments

  1. Early Retired Engineer says:

    The insurance rep who said they never paid out on an umbrella policy might be correct. What she may have omitted however was the expen$ive legal maneuving that helped them avoid paying anything. Legal protection is an additional benefit of umbrella policies. IMO, the higher the limit, the more aggressive the insurance company is likely to be in protecting their money.

    If you are living off your investment portfolio, especially one that is not protected from creditors, it is essential to have umbrella coverage.

  2. Darrow Kirkpatrick says:

    Thanks ERE, that's a valuable perspective. It would be nice having the insurance company's legal staff going to bat for you. Seems less likely that somebody would pursue a spurious claim in that case, though I don't know for sure. Anybody else have real-world experience with umbrella insurance and/or broad personal liability protection?

  3. Darrow,

    I am a case manager for a personal injury law firm in Florida. It is pretty rare that claims exceed the normal limits and move into the excess but it does happen. Typically, umbrella policies are purchased to protect an individual with assets from being personally liable.

    The underlying coverage is usually $225,000 or $500,000 before an umbrella (considered excess) coverage kicks in. While it doesn't happen often, it does happen where damages exceed the underlying limits.

  4. Darrow Kirkpatrick says:

    Thanks for the data JR.

  5. One proviso to this article is make sure your largest asset, your home, is fully insured in retirement! If one has a huge mortgage or is underwater there might not be a reason to fully insure (unless the mortgage requires it, which may be the case), but you need to insure your largest asset against loss!

    A couple down the street owned their home free and clear. A Fourth of July fire (from their bar-b-que, no less!), resulted in the loss of their home, which had been willed to them by her parents who passed away a few years ago.

    So don't chince out on home insurance if you have a great deal of equity in it!!!

    Disclaimer — I'm not an insurance agent or salesperson; nor am I a real estate agent or broker.

  6. Darrow Kirkpatrick says:

    I agree with you Craig. And note, even without much equity, there is an ethical/legal obligation for the debt. Our home is fully insured, though we carry a fairly high deductible. A prerequisite for self-insuring is that you have enough assets to make good on any losses! Thanks for the comment.