Insurance - Do I Really Have To Buy It?

Insurance is the type of subject that should be dealt with solely on logic, and yet people make snap decisions on whether to buy it, or how much of it to buy. In reality, what most young investors do when faced with any insurance products (not only health or life insurance, but also product warranties, house/fire, etc.), is weigh the chances of it happening against the potential loss if the ‘bad thing’ were to actually occur. In other words, they do an expected value calculation.

For example, if you were at Future Shop, and you just bought a brand new 52” plasma TV for $1000, (with HD technology and a March Madness channel pack) and then the store offered you an extended 3 year warranty for an extra $200 – would you purchase the extended warranty? Well, if you’re like most people, you’d try to guess the chances of the TV breaking down – maybe you’d ask the store clerk about it. Let’s say, you estimated that a quarter of TV’s (1/4) break down within three years. You would then apply the formula: (1/4) times $1000, which equals $250. Aha! – that’s more than the $200 price of the warranty, which means I should definitely purchase the extended warranty. Correct?

You’d apply this concept to most scenarios, even if you aren’t so mathematical. Should I buy house insurance against theft/fire? Well, you might reason, I live in a safe neighbourhood, therefore the chances of my house being robbed or burnt is very low, so I don’t think I need to buy the house insurance, especially since it costs over $500/year. In plainer terms, you’re looking at the price of the insurance, and then comparing it to the potential loss and probability of the accident occurring.

What’s wrong with this type of thinking? Seems logical, eh?

To understand why it’s wrong, think of it from the Insurer’s perspective. How does an insurance company make money? Well, they calculate the average amount of money they’d have to pay out, and then charge slightly higher to make their profits. For example, if a particular college student crashes his car on average X times a year which costs on average $5000/year in total, the company would charge maybe $6000/year in insurance. The insurance company would NEVER charge less (or even equal to) the amount they’re expecting to pay out for accidents. In the aforementioned TV example, there is no way the company would offer a warranty for the price of $200, if they expected to payout $250 on average. In fact, most insurance companies charge WAY more than the expected payout, as much as 200% of the expected payout! That means, if the warranty costs $200, the company is only expecting to pay $100, meaning that only 1 out of 10 TV’s break down within the first 3 years (not 1/4 as you predicted). Ouch! Maybe you shouldn’t have bought that warranty...

This concept should be pretty obvious to you. Yet, you still try to use expected value calculation to figure out whether to buy that insurance product, or how much to buy. We clearly need a new method here!

The method that most experts suggest is that you should really only focus on the size of the potential loss, and whether you can afford to take on the risk of the loss occurring. What I mean by that is, you should have a floor value of what type of loss you can take. For example, let's say that in your financial situation, you cannot afford losses greater than $1,500. If your house were to burn down, you'd be in big trouble. If your car were to crash, there’s no way you could afford to replace the car, or pay huge health bills associated with the crash. Conversely, while it would be really annoying if your $500 TV broke down tomorrow, it wouldn’t be the biggest deal. You could live with the $500 loss. What I’m saying here is, you shouldn’t insure ANYTHING that is worth less than $1,500, which is the floor used in our example. However, you can’t take chances on bigger things. Even if the chances of your house burning down are really, really small, what happens if it does? You cannot afford that situation. The RISKS involved are too great.

Case in Point: If I told you not to insure the next printer you buy, and then it actually did break down and you lost your money, you’d be a bit upset with me. However, you would probably still continue to read this blog. But if I told you not to get car insurance, and then your Porsche was stolen, you’d probably hunt me down. Why? Because, that's a loss you cannot live with. There is actually a mathematical formula that represents this concept –it’s called logarithmic utility. Ask me to explain it if you like..it’s pretty simple.

So, my advice is to never buy insurance/warranties on small potential losses. For me, computer purchases are at the tipping point – sometimes I buy the extra insurance, and sometimes not. But if you’re a millionaire, you probably shouldnt buy extra computer warranties – you’re guaranteed to lose value on your money, and you’re better off putting that extra money in the bank, and I guarantee you that you will, on average, end up with more money than before, at the end of the warranty term. How can I guarantee that? Simple – I’m 100% sure that Apple Computers is ripping you off with their insurance product – that the price of their warranty is higher than what they expect to pay you out. And believe me, Apple knows best when it comes to how many of its computer break down and are needing of warranty repairs.

Finally, to even further illustrate this point, I can pretty much guarantee you that Bill Gates does not purchase warranties or insurance on anything (regarding his household life; I’m not talking about his company/overall net worth). Think about it.

How can we apply this concept to car or health insurance? Well, what many experts advise is that you should look into buying an insurance product with a high deductible. This means that the insurance company only pays you out when the insurance claim is higher than the deductible amount. For example, I can buy car insurance that has an $800 deductible, which means that any damage worth less than $800, I have to pay for. Only if the damage tops $800, will the insurance company chip in. Insurance companies will almost always give you cheaper premiums as your deductible increases, since their expected payout is less. Why should you do something so crazy as too get high deductibles on your insurance? Well, for the same reason mentioned above – the losses worth less than $800 are losses that you can live with, so there’s no point in paying insurance premiums that, are on average, going to be higher than the expected pay out. Only the losses that you cannot afford to take a chance on, should you be insuring against.

So in conclusion – when deciding about whether to buy insurance/warranties, focus on the risks of that accident happening. Can you afford to risk not buying insurance against the relevant loss? What happens if the accident occurs – can you live with that situation? This method should give you an approximation of your floor insurance price. For some people, its $500. For others, it could be $500,000. Either way, it’s important to keep this in mind when faced with any insurance product.

Note: Life insurance is slightly more complicated and involves a different set of rules – ask me about it if you’re unsure and I’ll tell you what the consensus opinions are on that.