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Insurance is ALWAYS a Bad Investment (but often worth the money)

We all want to have insurance. Carefully selected coverage is an important part of any comprehensive financial plan and our budgets should include the money for premiums. For all of our lives car insurance, homeowner’s insurance, health insurance and maybe life insurance have been things we just assume are necessary. These days there are also a lot more insurance options on offer.  Longevity, supplemental healthcare, disability, personal liability (umbrella) and on the more extreme end of the spectrum terrorism, pet healthcare, cancelled vacation and even alien abduction insurance.

Deciding what to insure against how much coverage to get and what to pay for it has a big impact on our finances.  This determines what we pay now in premiums, and what the impact of life’s unexpected surprises will be on our financial well being.

budgets, retirement planner and personal finance blog
You don't need alien abduction insurance.

I suggest the first most important thing to keep in mind when deciding the insurance you need is that strictly speaking it can never be a good investment.  In other words, the odds of collecting and how much vs. premiums paid is always a losing bet.  The expected return is negative.

Insurance companies have teams of actuaries and access to ample statistical data to ensure that this is the case.  Given there are operating budgets including things like salaries and profits to be made, any insurance company that pays out in claims anywhere near what they collect in premiums on aggregate will go out of business fast.  For example, the very reputable State Farm Insurance Company collected $33.21B in premiums in 2012 and paid $21.52B in claims.  That means they paid out about 65 cents on the dollar of what they collected.  This suggests that if you are a customer of theirs, over a sufficient given period of time the most likely outcome is that the money you would receive from claims would amount to 65% of what you paid in premiums in that same time period.

This doesn’t mean insurance is a bad idea.  It does mean that insurance is best viewed as a price you pay to mitigate the possibility of costs that are large enough that their impact on your life is not fully captured by the dollar amount of the cost. This can manifest in a couple of different ways.

  • An amount that would ruin us financially.  For example for most people a catastrophe incurring them $1,000,000 liability would be much more than 100x worse than a $10,000 liability.
  • The inability to get what we badly need.  For example effective treatment for a life threatening health crisis that would cost $1,000,000 is worth far more than that to the person who needs it.  Someone who would not be able to afford such a treatment would rationally pay insurance premiums that they could afford against such an eventuality even if the expected return on the premiums were negative due to the low likelihood of such a crisis occurring.

So when deciding on insurance where you pay all of the premium (vs. say an employer that pays most of it as a benefit), a rational way to think about it is DO pay to insure for things you may plausibly need but could not afford, or against losses you could plausibly suffer that you could not absorb without dramatic impact on your well being.  DO NOT insure for things you can afford or against losses you could absorb and recover from in a reasonable time period.  When you look at it this way the following things may be worth avoiding:

  • Higher premium policies of any kind with low deductibles
  • Insurance for somewhat routine and inexpensive things you can afford to pay out of pocket (Dental and Vision fall into this category for a lot of people)
  • Add-on riders that offer some small compensation for specific unlikely events
  • Paid product warranties
  • Supplemental insurance that covers deductibles you could afford to pay if you had to

There are a lot more examples, these are just some common ones, but in the end if your insurance is reimbursing you for something you could have afforded to pay yourself, at some point you probably made a bad bet.

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