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:
- They are required to, by the government or by their bank.
- To avoid extreme financial hardship.
- 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!