Making your own parachute: the merits of self-insurance

Making your own parachute: the merits of self-insurance

This article will be a little different to our usual material.

I want to talk (in very broad terms) about whether more of us should be considering self-insurance as a real alternative.

Of course, nothing I say should be construed as advice: it’s up to you to make your own decisions, or seek the help of an authorised and regulated financial adviser.

One of the things which sparked my thinking on this was my recent experience in a Carphone Warehouse (part of Dixons Carphone (DC.)).

There was a particular phone for sale for less than €300, and the insurance product associated with it cost €7/month. Over the course of a year, you could spend around 40% of the total price of the phone on its insurance policy.

This is an extreme case, but it got me thinking.

Another insurance product that I was examining recently was a form of income protection: if I am sick or injured, and unable to work, then this product will pay me some income, for a specified period of time, to help me get by.

That sounds nice, but at what cost?

A few quick calculations suggested that I would need to claim this benefit for one month, in order to recover a year of premium payments.

The terms of the policy are such that you have to be out of work for a period of time (e.g. 3 months) before you can claim the benefit. So I would need to be out of work for 4 months to recover a year of premium payments, 5 months to recover two years of payments, 6 months to recover three years of payments, etc.

For someone in good health who only misses a day or two of work each year through illness or injury, this doesn’t sound particularly attractive.

And there is no doubt in my mind that a very large profit opportunity exists for insurers who sell this sort of product.

That said, most consumers understand that insurance companies are profitable and that an insurance policy carries with it an expected loss. But they buy insurance anyway, because:

  1. They are required to, by the government or by their bank.
  2. To avoid extreme financial hardship.
  3. For peace of mind and other psychological reasons.

I can totally embrace the first and second motivations.

When it comes to the third motivation, however, I think there might be opportunities for financially sophisticated individuals to skip town and go their own way. For those privileged enough to save and to get out of living from paycheck to paycheck, there is the option to strike an independent path.

Let’s go back to the phone insurance example, mentioned above.

Suppose that the customer has a savings pot which makes €300 seem like a harmless liability. Relative to their portfolio, it’s a negligible sum. If their phone breaks and the warranty doesn’t cover it for some reason, the customer will reluctantly buy a new one, without any financial difficulty.

In this circumstance, what does an insurance policy achieve? It’s not legally required. It won’t prevent extreme financial hardship. And it might not provide peace of mind either, except to the extent that the customer irrationally worries about the possible loss of €300 from their savings pot, in the unlikely event that they drop their phone and the warranty doesn’t cover it!

So the insurance policy arguably achieves little, and yet it certainly has a cost. This cost can be measured as the expected loss on the policy, and we can guess at this from the loss ratios reported by insurance companies.

The loss ratio is the claims incurred by insurance companies, plus their adjustment expenses, divided by the premiums they’ve earned.

In simple English: it’s the amount of money they have to pay out to customers, plus the cost of figuring out how much to pay, divided by the money they earn.

One major insurance company that I have examined this evening (FBD) generated a loss ratio of 56% last year. If I assume for the sake of simplicity that adjustment expenses were 1% of premiums (this could be wildly wrong), that means they paid out €55 to customers for every €100 they received from those customers.

So the expected loss, as an imaginary “average” customer, is €45 for every €100 spent in premiums.

That’s a lot to spend for peace of mind!

For individuals with larger and larger savings pots, I think it makes less and less sense to purchase small insurance policies (for things like phones, delayed flights, minor car damage, etc).

Income protection is another case where if the savings pot is large enough, the risk of hardship arising from being temporarily unable to work is very low.

Whole life insurance is a special case, because many people seem to treat this as an investment policy. It looks like a terrible investment decision to me, but certain individuals seem to be attracted to it. I cannot understand why.

I’ll leave it there for now. As far as the conclusion goes, all I’m left with is the determination to ask: do I really need this insurance policy? Will it be so bad to self-insure the risk, and build my own parachute? Let me know what you think!

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COMMENTS

Wordpress (10)
  • comment-avatar

    Interesting article and had come to the conclusion long ago that insurance for things like electrical goods/extended warranties was a waste of money. 

    I have even consider dropping house contents insurance. My experience has been £2.5 claimed/received for every £14 paid out. I asked my broker if I could cover just for total loss (i.e. fire burns house to ground and destroys everything/thieves back up a van and remove everything. The answer of course was? No. 

    This was after discovering that things like my sofa (a door frame would have be removed to get out of the sitting room) bed (which would need to be dismantled to remove it from the house) were insured for theft (as well as fire). 

    And of course one cannot cover only those things one wishes to for theft!!!

    Life assurance and IP if you have a family I think are essential. 

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    • comment-avatar

      Hello Graham

      I have always regarded Insurance Companies as a rip off outfits, and never took Insurance unless legally obliged to. So, in 50+ years of owning houses I have never had contents insurance.
      Remember Insurance companies, or their nearby equivalent, until Osborne changed the rule, could at the age of 75, swipe your savings, with the compulsory purchase of an annuity.

    • comment-avatar

      Very interesting that you calculated how much you got back in claims versus how much you paid in premiums – more people should do that, if they want to know what it’s really costing them!

      I would love to do the same, actually. Don’t need the sofa or bed insured, just the house!

      Re: life assurance/IP, I think there are a few factors which affect the need, e.g. the outstanding mortgage on the house and the availability of liquid investments.

    • comment-avatar

      Dendyver – well done for avoiding contents insurance! I’d like to do the same.

  • comment-avatar

    I think it all depends on risk levels , these vary so much depending on your own postcode , daily routine etc . A busy Londoner living in a dodgy post code would be well advised to insure thier Apple Mac . However I live out in the sticks with little theft . like many I dont insure white goods or phones and laptops . My brother owns several rental homes in Florida hurricane belt which he lets to holiday makers ….all un insured since the cost is very prohibitive . I would not sleep at night every time a hurricane comes through but he is a high net worth individual and just considers it an acceptable risk . I always insure my home and contents tho . People usually seriously under estimate the cost of replacing both contents and the building in a fire situation and they always forget the collosal cost of demolition and site clearance before even being able to start to rebuild again .

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    • comment-avatar

      wildrides… your brother sounds like he has a very high degree of risk tolerance! And/or must be very wealthy indeed to be able to shrug off the hurricane risk in Florida. Just goes to show the wide variety of circumstances different people face.

      At the end of the day it’s a personal decision, but I certainly would want to insure against fire and would not need to be compelled to do so!

      Thanks for the feedback. G

  • comment-avatar

    A good article. Throughout my life I have never bought insurance other than when it is legally required to do so.

    In the same area as insurance is warranty. I recall many years ago when dealing with a multi-million pound piece of equipment we had to get the customer to sign the warranty agreement. The reason was that the customer effectively signs away some of their consumer rights by so doing. Better to pay out on a warranty claim than end up in court with a judgement far exceeding what would have been paid out in warranty! In some circumstances the customer also has to pay for the warranty.

    I believe in the UK you have several other protection schemes such as consumer rights and I think you also often have some sort of protection when buying things with a credit card.

    You seem to dismiss the third option of “For peace of mind and other psychological reasons”. Sometimes people can just sleep well at night believing they are insured even if on reflection it makes little financial sense. Some things cannot be measured in dollars and cents. What I find particularly heartbreaking is when someone has been paying for an insurance policy for many many years believing it is the ‘right and responsible” thing to do, especially if the premiums are a significant part of their salary and when a claim is made they either find they are not covered for some technical reason or, as I have seen, the agent was just pocketing the money every month for several years. Whilst this may not be so prevalent in the UK it is unfortunately so in Asia. The big companies like Prudential, Aviva take advantage of unsuspecting clients in this manner and because there is little oversight by the authorities then they get away with it. It makes me fume seeing hard working individuals get scalped in this way.

    ‘Self-insuring’ is probably more suited to individuals who are relatively well-off to begin with as they can absorb the occasional shocks to their savings. The real issue is, I think, the insurance companies selling products designed to maximise their profits in preference to actually providing realistic coverage for adverse events. But such is capitalism…

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    • comment-avatar

      Very interesting stuff, Carcosa.

      It sounds like you hate insurance even more than I do.

      Quite a few years ago, I decided to buy insurance from my bank as part of a premium current account package. Quite simply, it looked like good value at the time. To the best of my knowledge, this account is no longer offered by the bank in question (Barclays).

      Thankfully, this insurance came in useful as I claimed a new phone under the policy after my own one was stolen. So I won that particular bet against the bank/insurance company!

      Good point about extended/special warranties.

      Re: peace of mind, I acknowledge that people have a need for it but as I say in the article and on this point I think you agree, “there might be opportunities for financially sophisticated individuals to skip town and go their own way.”

      Individuals with a stronger understanding of the product market and in better circumstances can take calculated risks which other people can’t, and can avoid fattening up the profit margins of financial services companies. Perhaps we can even say that this logic applies not only for insurance but for financial services as a whole and indeed for the market and for life in general: knowledge is power!

  • comment-avatar

    Good article, and totally agree Graham, and this is an approach I have been following for some time now. Most insurance products are not good value, although one area that I would recommend is in having good legal insurance cover, and this has been very worthwhile for me over the past five years. The sums involved can be vast, and it is the confidence that you have going into such a scenario, knowing that the costs are covered that permits you to sleep at night.

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    • comment-avatar

      Much appreciated, thanks TT. Legal insurance is indeed a special case. I think there’s a strong argument for directors and officers liability Insurance. G

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