Tuesday, December 15, 2009

Good Insurance vs. Bad Insurance

Here's the dirty secret of insurance - it is a loosing bet for the person purchasing it. Always*.

Insurance companies will usually have a loss ratio of 50 to 60%. The loss ratio is just another way of saying, how much they pay out in claims for every dollar they take in. They also have expense ratios in the 20 to 40% range (the cost to run the business- claims adjusters, salesmen, marketing, electricity, rent, etc) so don't think they're making out like bandits.

But from a consumer perspective the average insurance policy has about the same expected value as a lottery ticket - you can expect to get back about 50% of the money you put in.

But everyone in personal finance says you should make sure you are adequately insured.

There seems to be a tension between these two statements - 50% expected value, but still buy it? The resolution to this tension is the word "adequately."

Quite simply put, you should only buy insurance against those things you couldn't afford to bear the cost of yourself were they to happen.

Medical insurance - in the US today medical insurance is a hybrid of three things - prepaid consumption of health care, volume discounts for health care, and catastrophic medical expense insurance. Even if you are a healthy 25 year old male - with expected cost to see your personal doctor once a year of about $300 to $500 - it still would make sense to pay $400 a month for medical insurance because if you are in a car accident you could quickly rack up $50,000 or more in medical bills from the intensive care unit. Even though you expect to loose almost $4,000 a year on the wager, you can't afford the $50,000 if it were to happen. Thus you should buy it.

Car insurance - you pretty much have to have this to drive your car anywhere. But, what kind to get and how much should be dictated by the question "can I bear the cost if this were to happen." Chances are you can afford to pay $150 to a tow truck in the 1 in 10 years event that you get a flat tire and are stranded. So the $3 per month = $36 per year = $360 per ten years proposition of "roadside assistance" is a loosing bet, and one that you don't have to make.

Life insurance - Why do you need it? Could your family survive were you to die and not provide income? Chances are, the answer here is, probably not. What if you have a stay at home spouse? Should they not be insured because there would be no lost income? Not if you have kids. A stay at home parent is engaging in "invisible" productive activities - there is no money coming in for them, but there is usually a substantial savings in money that would otherwise have to be spent. So, what would the cost be to get childcare if that spouse were to die? That's how much life insurance the stay at home spouse needs. What about 10,000 coverage for babies? Unless you can't afford the basic costs of a funeral, stay away. Same for married dual income no kids, unless you have a mortgage that requires both incomes.

Cell phone insurance - You should insure yourself here. If you keep loosing your phone, either stop drinking so much, become more responsible, or learn how to google "Refurbished __your_phone_here___." You think of it as "it saves me from paying $200 for a new phone" but, they send you a $50 refurbished model - and charge you $3 per month to do so. This is one of the biggest wastes of money. Cell phone insurance is the WORST kind of insurance.

Disability insurance - This is going to cost you peanuts, and be happy every month that you're paying so little even while expecting to loose money. This means the chance of you becoming disabled is vanishingly small. Be happy about this fact, and by all means make sure you are covered.

Good insurance buys you security. Bad insurance is like buying a lottery ticket. Think about it so you make sure you know what kind you are getting.

* I said above insurance is always a loosing bet. I should restate - it is always a loosing bet if the insurance companie's actuarial tables are correct. That is, you can only profitably take on insurance if 1) you know something they don't about your risks, and they don't ask or 2) they've done their math wrong. Now, I know some guys who do math for insurance companies, I wouldn't bet against them.

Special proviso on "gimick" coverage. Sometimes insurance companies intentionally under price small elements of their coverage - i.e. laptop breakage. They do this because they know that having this gimick is going to make their insurance more desireable - it is a classic loss leader. They loose $10 on laptop insurance to make $100 on the homeowners policy. It is a sales cost for them, and you should by all means take it. But, if you can't do the math, you should always assume that gimick add ons are correctly priced because 9 times in 10 they are.

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