Insurance: A Tax on People who are Bad at Math?
I recently read a Facebook conversation about health insurance where one person said, “I’m better off saving the $1000/month premiums and paying for my own medical bills if they ever come up”. And the other person said, “Bah! Recipe for bankruptcy! You need full insurance!”. Which person was right?
Years earlier, I was talking to a friend who had just bought her husband a Rolex watch as an anniversary present. As part of buying the watch, she also bought an insurance policy which would buy them a new Rolex if it was stolen. Was this policy a good idea too?
What about collision insurance on your car? And life insurance?
Insurance of all types – car, house, jewelry, health, life – is a crazy field swayed by lots of marketing, fear, and doubt. In fact, I’d bet most insurance is bought partly on fear and without doing any actual math on whether it’s a good deal. If you’re an average consumer, you spend several thousand dollars per year on insurance. Maybe there’s a way we can cut that down and let you keep some money for yourself!
The first thing to understand about insurance companies is that they are making money off of you – lots of it. They do this by employing a team of brilliant mathematicians called Actuaries who analyze detailed mountains of statistics about the average behavior of people like you, and thus how much money they expect to pay out to you in claims. They then strategically set your premiums to a level where on average, they can pay your claims, pay their employees, and still make a large profit for their shareholders. So they have, of course, rigged the odds against you. So when buying insurance, you will most likely pay in more than you get out of it.
This seems obvious, but some people still need a little reminder, because I keep hearing things like, “I need dental insurance, so I don’t have to pay the $300 every time I take my kid to the dentist!”. That’s a mindset that is imagining that insurance actually SAVES you money on average, which it does not – otherwise the insurance companies would all lose money – which they do not!
Once you understand this, you realize there are only three possible reasons to get insurance in any particular area.
- You’re forced to do it (car insurance laws, house insurance required by your mortgage bank)
- You can’t afford the consequences (A burned-down house or a year in the intensive care unit at $10,000/day)
- You are riskier than the insurance company thinks you are (you engage in drunken car racing or competitive eating events on the weekends). Or on a more serious note – if you are planning or expecting a baby, or have any known upcoming or chronic health conditions.. these are good times to plan in advance and set yourself up with a much lower-deductible plan. The US is an unusually expensive place to have a baby in a hospital, and even I wouldn’t advise risking paying for this out of your own pocket. The cost will range from $3,000 to $1 million+, depending on complications you cannot predict in advance.
That covers the main categories of insurance. But what about things that you can’t afford but are really unlikely? Do you get kidnapping insurance on yourself to cover up to a $3 million ransom? Identity theft insurance? Insurance on your kids? Extended warranties from Best Buy on your new laptop?
Stop! It’s all a trick.
Luckily there is a solution: Get almost none of it. Especially if you already have a healthy ‘Stash of savings built up and could thus afford any unexpected expenses.
Since you’ll be driving only affordable used cars with no bank loans, get only liability insurance. Since you will be keeping yourself healthy for life, get only a “catastrophic” type of health plan where you pay ALL your own bills unless the cost exceeds $5-10k in a given year. Since you will be building up savings and cutting your living expenses, and you are very unlikely to die in the next few years, you may not need any form of life insurance. My wife and I have never carried life insurance on ourselves, and we consider it a compliment to each other: “I believe you would do Just Fine if I wasn’t around, because you’re a capable and independent person”. Get the highest deductible on your house insurance that the mortgage company will allow. Or if you have no mortgage, the highest you are comfortable forking over after an incredibly unlikely event (my deductible is over $10k).
Then for the insurance lines that you are keeping, do a nice afternoon of shopping around – I did this last January and sliced about $300 per year off of my remaining home and car insurance. The winners for me ended up being subsidiaries of Geico, although different people will find their results vary with different insurance companies, strangely enough.
Then put all the savings from these premiums into growing your nest egg, realizing that you are now getting paid to be your own insurance company.
It sounds risky if you let the fear creep in. But it should actually feel deeply satisfying and safe. By not buying into a product where the odds are stacked against you, you are STATISTICALLY likely to win. We can’t predict the future, but we do have one tool that lets us turn the unknown to our advantage, and that is statistics. They are my best friend when it comes to becoming wealthy, and they should be yours too.
The savings of thousands per year will add up alongside all your other newfound riches from frugality, and you’ll soon find that none of these potential expenses will scare you. Over the past 10 years, I’ve saved about $40,000 in insurance premiums compared to the average level of spending, and now that $40k is sitting alongside my other employees, producing $2800 of passive income each year, and already more than big enough to cover replacing a crashed car or paying any possible deductibles on medical bills.
And after 10 years of relatively exciting living, I haven’t even had to dip into it once. Now I see why insurance companies make so much money!
A Credit Card with a $400 Signing Bonus… WTF?!
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Ok – so maybe you answered this – but if you or a family member is chronically ill, what kind of health insurance should you get? We’re talking hundreds of thousands of dollars in medical bills without insurance. But there are options – high deductible plans, and also the traditional kind. And a secondary insurance that requires primary insurance if offered at employer. I’ve never looked into the high deductible one, but perhaps that is a good option? And life insurance (term only) because you a primary caregiver for someone who is disabled for life? What about beyond the term? Perhaps I need a shift of thinking and don’t even know it.
That’s per year. Continually. Forever.
Very good point, Jenny! I was incorrectly assuming everyone in the world is already in perfect health with no need for medical care.
In the situation where you have a known stream of medical bills, you fall squarely into my category of “you are riskier than the insurance company thinks you are”. For you, insurance is actually profitable to buy. So in that case, you work out the best ratio of annual deductible (which you will always be paying in full) to annual premium cost. For example, if you can lower your deductible by $5000 for less than a $5000 increase in premium costs, you should do it. Your ideal health insurance plan might therefore end up being a very high-end one.
In the very recent past, a person like this could only get coverage if they could get a job with an employer that offered a strong healthcare plan allowing pre-existing conditions. Otherwise they would be denied any health insurance, since it would be a guaranteed loss for the health insurer. So the only solution would be to go straight to poverty and bankruptcy, then get occasional assistance from Medicaid. With changes from the new Obama health plan that passed this year, even people with less fancy jobs will still be able to get health insurance. I think he had to bribe the insurance companies for this concession by adding a pool of healthy young people all getting insurance as well – hence the eventual requirement that everyone get insurance. But an added benefit is that universal insurance also cuts down drastically on unpaid use of the emergency room.. which provides some of the savings to pay for the care of the chronically ill.
Love reading your blog :)
You don’t even think you should carry term life insurance if you have children? I would worry about not leaving them enough money to live until adult age.
Thanks Laura!
The term life insurance for the kids really depends: For a family with two parents around, the chance of both parents dying simultaneously is even lower than the chance of one dying. It is getting down into the “kidnapping” probability of things I wouldn’t even worry about myself.
But since we all love our kids and don’t like the idea of taking any gambles with their future, how about this idea: make an agreement with one of your own grown siblings, your parents if they are young enough, or even a close friend, that they will adopt your kids in this highly unlikely situation. Then in your will, leave all your assets to your kids. It costs very little to add a kid to an existing household, so even a tiny inheritance will pay for their trip to adulthood.
We pay for term life insurance on my husband each year. We look at it year by year and our kids are under 5 so we figure its worth losing $100 so I could take care of the kids if he died and provide them with the stability of lots of time with me. We are also paying for the preference of my sister getting the kids if we both die. She couldn’t afford this change in her life without the insurance. Right now, our assets wouldn’t change this significantly.
I suppose it would make the most sense to get term for a working spouse if you had one stay-at-home parent. Currently we both work, no kids yet but in the near future :) so thinking ahead. Thanks for the reply!
We have term for both of us, simply because paying the mortgage on one salary would be tight. We could do it, but it would be tight. So trying to do it with the stress of being a single parent (were one of us to die…) too much.
Its also possible to buy a form of term life insurance that pays only in the event of both parents dying and leaving behind dependant children. Talk to your insurance broker, but a policy like this is a necessity in my opinion and (as the chances are so unlikely) it normally works out very cheap.
I used to work for an insurance company. I ate some very good meals during those days. Stayed in the best hotels. It was great. So just get a job at a big insurer, which will insure a very pleasant lifestyle.
Great post.
I have comp/collision on my new car for now – I could afford to buy a new one but it would but a big dent in the ‘stash (I bought new but for cash. I *had* to do it once! :) ).
I definitely don’t have pet insurance – there’s almost nothing that it would cover that costs more than I can pay, and by the time my dogs are old enough for really expensive care, I should have a much bigger stash (and hopefully be retired).
Life insurance is cheap but I’ll probably drop it when I’m 30 (I’m 29 in a couple of weeks) as there’s nothing I’d burden relatives with that I don’t have assets to pay for, and my self-employed (not yet earning) DH could easily find a new job.
Health insurance is hard but fully provided by my company for now. I have asthma and some allergies, so I’m a pre-existing-condition problem waiting to happen if I dump it. I’d need a bigger stash first.
I totally agree, self-insure if at all possible. True story – last year my (small) employer discussed dropping their health plan, which really only covered 3 of us. I set out looking for a replacement plan for our family of 3, soon to be 4.
We ended up getting a high-deductible plan that is HSA compatible for HALF the price of the employer plan – $400 vs. over $800/month. We started banking the difference and just about have our $5k deductible saved up. I truly enjoy paying myself $400/month rather than send it to the big bad insurance company. Not to mention the out-of-pocket max per year is actually LOWER by $1,000/year. The only caveat is we have a 12 month waiting period for maternity coverage, but since my wife just had the baby a month before we started the new plan, it was good timing for us.
Double bonus – in January the insurance company screwed up their billing (due to the health legislation) and instead of fixing it for the next few months, just told us to keep paying the new premium amount of $340.
+1.
I’ve saved so much money on insurances compared to my peer age group in the first 7 years since I left uni. I am now independently self-insured except for catastrophic incidents (which would be life-threatening cancer, third party liability and the like, which does NOT include unemployment, car damage, a rotten tooth or a two year old laptop malfunctioning). All savings from then on went into my own pocket and not into the insurance company’s executives’ compensation and share holder dividents. Makes me smile!
Insurance companies are advertising and marketing geniuses, so beware and keep real.
Fubek
Insurance is a hard one for me, I know typically people get way too much coverage and throw money down the drain with every coverage they can get. I yet have found a plan we can afford for health issurance. We are not on ANY government assistance ( a pride thing, I have always made it without so I leave it for those who may really need it)
However about 2 years ago now I had to face the fact I may lose everyone I love within a 3 month span. It was brutal and to be honest I shut down and came real close to a nervous breakdown as it was too much in too short of time. The losses would of included my mom, my dad, my husband and BOTH my children then ages 10 and 8.
So yeah health insurance is important to me I just don’t quite know what to do or where to look about it at the moment. AFLAC was a joke when I had it before and did not seem to cover anything that we came up with health wise!
Medical bills have also deveasted our credit and YES medical bills DO matter on your credit score when they are aggressive hospitals and place your ungodly high bills into judgements.
Oh but I do have a GREAT affordable plan if I die, I got two burning barrels out back!
Another great post, MMM.
I’m curious what folks think about long-term-care insurance. My parents are 53 with no retirement savings or pensions, and I’m already envisioning the drama that lies ahead. (I live 1,200 miles away–on purpose–but I’ve got way more resources than my sisters.) I’ve thought about getting LTC coverage on them, but it would cost $300-400 a month.
Anybody have LTC wisdom to share?
While I agree with the basics of this idea – not throwing money away on insurance for contingencies that we can cover ourselves – I do think we need to think carefully about just what we can cover ourselves. For me and my husband, we would both be devastated if the other died, having been together longer than we were single. Even though we could survive, it would be so much easier if we each had the option to not have to work in order to survive, for several months after being widowed. We carry a small amount of life insurance on each other, so we can have time to grieve without worries of paying the bills, and time to make some decisions about what may need to change in our life. It’s enough to live on, carefully, for a year or two, at our current lifestyle. My thoughts on this are probably influenced by my career in mental healthcare, as I care for people everyday whose lives are devastated by something, often outside of their control, and the last thing they need is the additional worry of having to return to work within a few weeks in order to pay the bills.
oh – and I meant to add that I’m really impressed with the HRA that my company offers. I went with it on its first year available last summer, and I’m staying with it again this fiscal year. It’s half the cost of the regular plan, and simpler to use. It is built on the premise that the more people are in control of, and responsible for, their healthcare spending, the more they will make good decisions. All prevention services are fully covered. For every other per person cost (meds, labs, doc visits, hospital, tests, etc) the first $750 is covered by the employer, the next $1250 is covered by the employee, and anything else for the rest of the year is covered by the insurance company.
The other plan I’ve had that I liked was a cost sharing system that wasn’t really insurance. Families paid a premium of about $250 a month, and the plan paid nothing unless the cost exceeded a thousand or so per event. It’s another system where individual responsibility is a big part, as we were expected to absorb the regular stuff, and use it as true insurance — for the big stuff only.
I do not agree to your view. First of all, I am not an advocate or affiliate of any insurance business, and do not have any biases. Having said that, my view is Insurance is a Risk policy , rather than anything else. What is covered under the risk is completely up to a person and what he values most in his life. I do believe that a person should not buy anything which will cause him to loose sleep over it, and if the “thing ” is lost, the consequence will be unrecoverable. So if a person wants to buy a Rolex, and can afford to loose the Rolex without much discomfort,he does not need the insurance. However, a young family should have adequate insurance in case the wage earner(s) gets disabled or is unable to work. This becomes a question of risk mitigation, rather than payment. IF you have built enough wealth that you can forgo the rest of your life without earning anything, by all means, laugh me out of town. But just in case you have not, what is your plan B?
Actually it sounds like we DO agree. I said you can skip buying insurance once you can afford the consequences of any loss.
And even better than buying insurance for losses, is becoming financially prepared for a loss BEFORE buying something. For example, save enough to easily replace your car before you even buy it. Save enough to not need a steady job BEFORE having children! I am glad I took this path, and although it is too late for most of us because we already have kids, I’d still highly recommend it to younger people just graduating today. Financial independence FIRST, then move on to the rest of your life!
I only get insurance when the dealer has an ace showing and the cumulative count is +3 or higher. *g*
Well, that, and the damned mandatory car insurance. (Somehow I doubt that’s what Henry Ford…) And then there’s the health insurance that’s mostly paid for by my employer – I think it costs me about $5 a month. I think I did fairly well in that respect… If you don’t mind my asking, MMM, what kind of insurance policies do you have?
Quick question – you mentioned that both you and your wife are from Canada. Now that you have the money saved up, why not move back to Canada and take advantage of the free healthcare, free/cheaper education etc?
That’s a good question! The families back in Canada sometimes ask the same thing. The only real reason is that it is way, way, way, way, nicer to live here in Colorado than it is in the Great Lakes region where we grew up. And on balance, it is still much less expensive to live in the Western US than in most Canadian cities, because things like housing, food, any sort of manufactured goods, and property taxes are so much lower here. It’s easy to save up any amount of money you might need just by taking advantage of the high wages and low cost of necessities.
Great post. I was curious what you think about Umbrella insurance? It seems like it might not be a bad idea once you have significant assets – it is relatively inexpensive. A lawsuit could really put a damper on the most carefully laid early retirement plans. It also seems like it might be a good idea to establish a LLC for each rental property you own. Thoughts?
Good questions, I’d like to hear MMM’s thoughts too. I have an umbrella policy and it’s pretty cheap, $14.25/mo for $1 million (MMM would say it costs $2522 over 10 years excluding increases). It actually paid for itself in my case because I got a discount on other policies.
I’ve heard about the LLC for each rental and think it’s a good idea but there is a big upfront cost depending on the number of rentals (I have 5).
This umbrella policy idea is new to me, so thanks for sharing. I’ll do some reading on it myself to get up to speed, since I plan to be a landlord for quite a while now – it is growing on me. It seems the wealthier and more involved you are with multiple tentacles in your local business community, the wiser such an idea would become.
I had already heard of the “separate LLC for each house” idea, and some people in my area definitely do this – you can see it when scanning the public property records.
jDeppen – I transferred your math correction into your main comment, so it’s simpler for future reading. Thanks again for the ideas!
This post strays too far into hyperbole, from the title, to the assertion that insurance companies make “a lot” of money off their policies, to the conclusion that the correct financial strategy is to buy as little insurance as possible.
This is unfortunate because conceptually you are right, an insurance company will charge a premium to the insurance buyer, above the expected loss on the policy. That doesn’t mean an insurance buyer is bad at math or is making an unwise financial decision. They are simply exchanging a known expense larger than their expectation value for lower volatility. Painting with a broad brush bonds generally have a lower rate of return than stocks but in exchange have lower volatility. That doesn’t make a bond fund a bad investment only a different one. Depending on your risk tolerance it may even be a more optimal one. I know you’ve written in the past that paying down a mortgage is a wise financial decision. Economically you will, on average, come out far ahead by investing that money in equities instead. By prepaying your mortgage you are taken a lesser known return in exchange for a greater average more volatile return. The concept is completely analogous although you come down on the opposite side of the debate in that arena.
It is important for people to think about insurance in terms of expectation value. You are absolutely right that some insurance can be priced so highly compared to expectation value that it never makes sense for anyone to buy it. Your dentist example is perfect, it makes no sense to buy “insurance” that covers an expense which occurs with 100% probability. That’s not insurance its a prepaid dentist visit.
Another good example is insurance on consumer products. My wife just bought an Iphone and they offered her a two year insurance plan. The plan replaces her phone, a $700 item, but costs $250 up front. We’ve each owned a cellphone for 10 years, or 20 years of cellphone ownership. In that time we’ve only lost or broken a single phone. That’s a very unscientific 5% annual loss rate on phones. Her expected loss for owning an Iphone is 5% * 2 years * $700 or $70. I’ve never seen a one off consumer insurance policy that wasn’t grossly overpriced.
So in theory I agree with your sentiment that insurance costs more than on average than bearing the risk yourself. I usually opt for high deductible plans for myself, I despise the fact that my medical insurance covers too many everyday expenses, and I turn down every policy that I get offered when purchasing a consumer good. But I don’t agree with your conclusion that insurance is bad, that insurance buyers should feel bad about their purchase, or that they are “bad at math”. It’s simply a personal decision about risk tolerance. If you are completely informed about the cost of your decisions and still want a no deductible gold plated medical plan more power to you.
I don’t me to come off as overly critical, I think the topic is incredibly important and I agree that most people are quite ignorant of the economics underlying it. I think that one major reason for this is that the most costly insurance policies people are involved with are for medical coverage. Pricing in the health care market is completely opaque, there is no way to know what treatment costs so it cannot be compared to the cost of insurance.
OK, Mr. Fussy, I added a question mark to the headline just for you, to tame the hyperbole a bit. ;-)
Hi Mr MM, great blog.
I think you are way too lenient on that reply. Your assertion is, in general, quite correct, and if readers actually read your whole post, and ideally all your blog posts, they’d not ask such dumb questions as some of the above posts.
Insurance absolutely IS about combining risks and thus flattening out the payment curve for anyone needing to claim, but anything short of a long term recurring liability like an illness (at least for you guys in the US of A, unlike us in the UK, who pay for our chronic healthcare out of taxes, but seem to pay less than you guys in the round) will almost certainly never cost in. As you say, insurance companies don’t only need to make a profit, they need also to pay their bills, rent or buy their buildings, pay their staff, pay their taxes – all coming out of our premiums.
And they really do rely on fear factor and people not understanding the math. Ever see a TV ad for an insurance company explaining the statistical likelihood of your claims outweighing your premiums over your lifetime, or even a 10 year period? I thought not !!
We self insure on most things these days, and have never ever taken out insurance on individual household items, and in the main would never have had to claim if we did, thus saving several thousand pounds, which by now would pay for any appliance or TV that now failed, several times over. This insurance in particular is all about the maths.
Keep up the good work.
Tony
I have long had this very same discussion with folks… and find it almost impossible to convince them.
There was a time where I “retired” for a few years. (By retired, I mean I decided on my own to quit my job, move somewhere and set up shop, then sort of just waited for another job to come along. It’s one of those things one can do if one has a ‘stash.) I found that the difference in premiums on high deductible and low deductible insurance was such that in one year you saved enough to cover the deductible. One year! So, you save $10k or so in premiums… ‘stash it away as “this pays my deductible next year”… and you’re done. Forever. Now that extra $10k the next year can go towards… buying house… buying mutual funds… hell, you can set it on fire and stay warm if you really want to — it beats giving it to someone else for something you hope to never use.
I’ve heard that rather than buying life insurance, it’s better to buy disability insurance, and you’re way more likely to be disabled than losing your life.
A quick comment re health insurance:
It’s unfortunately the case that when you are paying cash for medical expenses, you are paying 3-4 times what an insurance company would pay them. It is one of the big problems I have with the US healthcare system.
In a way, I consider a high deductible insurance plan a form of membership where you get the same rates that everyone else does.
Actually, you can get the same deals that the insurance companies get – I read an article about this once and there are in fact entire books on the subject. The basic idea is, you get in touch with your preferred hospital in advance and set up an account with them with the pre-agreed discount. They are happy to do this, since an individual with good credit is much easier to get money from than an insurance company, which makes a point of being annoying about every single claim.
I have to disagree with that MMM on setting up the healthcare deal with a hospital. You cannot predict which hospital you will need or what type of procedure/specialist you will require and will still get slapped with a bill 3-4x the amount. I have personally watched this happen to people – and it happened to me once when I was mislabeled ‘self-pay.’
Of note, you should never let your health insurance lapse if possible. Use COBRA or at least something. I got a new job and we decided not to cover my spouse since his job in a few months would be providing health insurance for much lower premiums. When we looked at the fine print, by allowing your insurance to lapse, you open yourself to denial for pre-existing conditions. We ended up paying for his COBRA – oh, and he’s an ex insurance broker so we aren’t bad at math either.
Everyone needs to make some type of plan for continuing health insurance, period. You can play with the plan, the rate, the deductible based on your current age and health, but the natural conclusion to life is death. If you want to save some money, stop smoking. A pack-a-day habit is about $223 a month and killing you.
Nice write-up and good points. You might be interested in this book excerpt about insurance: http://www.theglobeandmail.com/globe-investor/personal-finance/the-lowdown-on-insurance-salesmen-and-warranty-peddlers/article1516009/singlepage/#articlecontent
I like the idea presented there of thinking of insurance as a way of “smoothing across universes”, the conclusions are pretty much what you came to here, but with a bit longer explanation, and a bit less swearing. If the rest of the book is as good as that excerpt, I might be interested in reading it.
What about purchasing a whole life policy with built in dividends. Some can grow at 7% annually and offer dividends. At the end of a term you’ve got your stache right there, plus all the while it grew tax free AND is protected from creditors/lawsuits. Also if you die it pays. Not the worst thing ever.