Money Sundays: Two Easy Rules To Value Insurance Coverage

This is a long and borderline wonkish post on insurance that follows up last Sunday's post Is All That Insurance Really Worth It? If insurance bores you even in the slightest, feel free to skip reading it.
Commenter Brittany disagreed with some last week's suggestions on reducing insurance costs:

"But it was only about $10-$15 more a month to have comprehensive instead of liability only or to go from a $250 to $1000 deductible. And saving $150/year while giving up protection on a $5000-$10000 asset strikes me as pretty penny-wise, pound-foolish.

Renter's insurance also cost me $15/month. Yet my exploding water heater and related flooding did $1500 worth of damage in only a few hours, and it only damaged two rooms. (And I don't even own that many nice things!) If I think I am going to have an equivalent disaster more than every 8 years or so, I'm ahead by having insurance."

Okay, there's a lot going on in this comment, and some things we can all learn here, so let's address Brittany's points one at a time:

But it was only about $10-$15 more a month to have comprehensive instead of liability only or to go from a $250 to $1000 deductible. And saving $150/year while giving up protection on a $5000-$10000 [car] strikes me as pretty penny-wise, pound-foolish.

There are two concepts here: the idea to hike your auto insurance deductible, and the idea to drop your car's comprehensive insurance coverage. Let's address them separately, starting with the deductible.

Here's the thing. In the example above, hiking the deductible to $1,000 is a total no-brainer. To explain why, I'll first share an important fundamental concept and I'll then share an easy rule of thumb that readers can use any time they want to assess the relative value of insurance coverage.

Understand your incremental liability
First the important fundamental concept, one I want to make perfectly clear to all readers: When you hike your deductible, you're not giving up protection on the entire $5,000-$10,000 car, you're only giving up protection on the difference between the deductible amounts. In other words, your incremental risk from hiking your deductible is only $750--the difference between $250 and $1,000.

Trust me, you do not want to pay $150 a year to protect yourself from a measly $750 dollars' worth of potential incremental loss.

The Premium/Incremental Liability Rule
Which brings us to our rule of thumb to value insurance coverage: To see if a change in an insurance policy is worth considering:

1) Take the amount of premium savings and divide by the incremental liability you take on by cancelling that coverage.
2) If the resulting percentage seems high to you, and if you can easily cover the incremental liability, drop the coverage.

Further, you can use this rule in reverse to consider whether it's worth adding coverage:

1) Take the premium cost of the insurance policy and divide by the exact liability the insurance company will cover.
2) If the percentage seems reasonable (or low) to you, and if you cannot easily cover the incremental liability, consider buying the policy.

I hereby deem this The Premium/Incremental Liability Rule. You can use it to help you assess most types of insurance. So let's apply it, and see if hiking your auto insurance deductible is as much of a no-brainer as I claim it is.

First, your premium savings from hiking the your deductible from $250 to $1000 is $150 a year. In exchange, you increase your potential liability by $750.

So, divide. $150 divided by $750 is 20%. That seems high. Really high. Is it really worth it to you to pay 20% (twenty percent!) to have the right to maybe use $750 of some insurance company's money? Worse, note that the actual returns to the insurance company here are in reality far higher. After all, only a small percent of drivers get into accidents and file claims every single year.

The bottom line is, keeping low deductible tends to be pretty darn expensive. And now, you've got a simple calculation to help you see exactly how expensive. Further, you have a far better alternative: you can protect yourself... for free. As we discussed last week, save the extra $750 in incremental liability in your household emergency fund. Pocket that $150 a year in premiums that you would have paid out. And then instead of paying an insurance provider 20% for their money, you can earn that 20% yourself in the form of premium savings. In today's ultra-low interest rate environment, it's pretty hard to find any investment that beats hiking your auto deductibles.

Never pay through the nose to insure a loss you can easily cover yourself. An incremental cost of 20% for a measly incremental liability of $750 clearly qualifies as not worth it. As always, your mileage and your policy may vary, but in this stylized example, we have a total no-brainer.

Comprehensive coverage
Okay. Let's move on to addressing comprehensive automotive coverage. In Brittany's example, she also states she could save $10-15 a month (or roughly $150 a year) by dropping comprehensive coverage on her car. So once again let's apply our rule of thumb.

What's the premium? $150 a year. What's the incremental liability?

A-hah. Okay, this is a little harder to assess. First we have a car worth $5,000 to $10,000. For the sake of argument let's take the mid-point and use $7,500.

But wait: you have to pay the deductible, so in this case you are responsible for the first $1,000 in losses. The insurance company picks up the rest. Therefore, the insurance company agrees to cover up to $6,500 in losses. This is your denominator.

Great. Now divide: $150 divided by $6500 is about 2.3%. And here, we actually see a fairly compelling case for keeping comprehensive coverage. 2.3% is not that high a cost to pay for money, and $6,500 is a far more meaningful amount of potential liability.

Which brings us to yet another ironclad rule of insurance: If you don't have the resources to meet a loss, you should insure it. However, if you do have the resources, you can use our simple premium/incremental liability calculation to help you decide if the insurance is actually worth it.

Warren Buffett's $7,500 car
Before we move on, I want to go over one more nuance. Let's imagine Warren Buffett owning this $7,500 car. [Don't laugh: Buffett actually maintains surprisingly modest lifestyle.]

What would Buffett do? Well, clearly, he wouldn't insure this car no matter how the numbers worked out. After all, the car's value is insignificant compared to his overall financial resources.

This gives us another useful prism to help us consider the relative value of insurance: compare it to your resources. I hereby call this idea of considering the value of insurance in the context of your available financial resources The Warren Buffett Prism of Insurance.

Look, you don't have to be Warren Buffett to rethink insurance, I'm just using him as an example. But the point still stands: as you travel your own financial road, saving aggressively and carefully building your wealth, you will find yourself reconsidering many of your views on insurance. You'll see more and more value in hiking your deductibles, and you'll see more value in switching to simple, low-cost, catastrophic coverage. And you'll start see zero value in some forms of insurance that previously you couldn't imagine living without.

Why? Because you already have a cheaper and better source of funds--your own aggressively accumulated savings.

Some of these ideas may seem outlandish to you at this stage of your financial life. Indeed, some of these ideas are totally contrary to the conventional wisdom out there about insurance. But you didn't come here to Casual Kitchen for conventional wisdom, did you?

[Gratuitous plug: For more on how to save aggressively so you can begin to make decisions like this, see my in-depth series on Your Money Or Your Life]

I know this post is getting long here, but we're almost done. Let's move on to addressing Brittany's comment on rental insurance:

Renter's insurance also cost me $15/month. Yet my exploding water heater and related flooding did $1500 worth of damage in only a few hours, and it only damaged two rooms. (And I don't even own that many nice things!) If I think I am going to have an equivalent disaster more than every 8 years or so, I'm ahead by having insurance.

Okay. If Brittany has $1,500 worth of things in two rooms, let's guesstimate that all of her rental assets have a total insured value of $2,500. Remember, I'm just trying to show an example for the benefit of readers. You can plug in your own numbers from your own policy, and use the fundamental principles of this post to decide for yourself if your policy is worth the cost.

Another point: keep in mind that some of the liability of an exploding water heater will accrue to the property owner, not to Brittany. Because she's a renter, she won't be responsible for floors, carpets, walls, some appliances, and so on.

So, first, apply the Premium/Incremental Liability Rule and run the numbers: $15 a month is $180 a year. $180 divided by $2,500 is 7.2%.

Hmm. This number is kind of a tweener. It's not ridiculously high like the 20% rate on hiking your auto deductible, and it's not attractively low like the 2.3% rate on comprehensive coverage. We don't have a clear answer yet.

Next, apply The Warren Buffett Prism of Insurance. Ask yourself: can I easily come up with $2,500?

If you can't easily come up with $2,500, keep the coverage. Simple. However, if you do have $2,500 easily available, look at that 7.2% and decide if that's a rate you're willing to pay for protection from a loss you can easily cover yourself. Remember, the insurance company can only give you money, they cannot replace your stuff. Insurance--no matter how much you buy--cannot grant you immunity from misfortune.

Use these rules. And let me reiterate: as you continue to accumulate savings and as you continue on your journey towards financial independence, you will find more and more instances where insurance simply doesn't provide as much value as it used to.

1) Hiking your deductible and saving on your insurance premiums is (usually) a no-brainer. Consider it.
2) Understand the incremental liability you're taking on when you make changes to your insurance policy. Make sure you've saved that amount yourself before you drop coverage.
3) Use The Premium/Incremental Liability Rule to help you assess the value of insurance. If you arrive at a rate of 10% or higher and you can easily cover the liability, consider dropping that coverage.
4) Use The Warren Buffett Prism of Insurance to help you consider the value of the insured item in context of your overall financial resources.
5) As you save money and carefully build your personal wealth, you'll find less and less value in high-cost, conventional insurance policies.
6) Insurance can only protect you from financial loss, it cannot grant you immunity from misfortune.

Readers (uh, those of you who made it this far), share your thoughts!

Related Posts:
On Timeshares, Beware
Do You Let Yourself Be Manipulated To Buy?
What Is a Scarcity Mindset? Investing and Living In a Zero Sum Paradigm

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chacha1 said...

Thanks for the follow-up. I just read back to see what else Brittany had written and here is the clarification on our insurance bill.

Yes, health insurance was by far the biggest part of the monthly nut - $600/mo on my company's group plan. We have since reduced that to $400 by self-insuring with Kaiser on a high-deductible plan.

High deductible means $8000. So we are liable for up to $8000/yr out of pocket.

But to us, saving $200/mo guarantees $2400/yr that is NOT going into the pockets of insurance companies, some of the most profitable and least productive companies on earth.

For the past ten years, the RETAIL value of the health care we've consumed has been less than $500 apiece, whereas we've been paying out over $7K in insurance premiums. We are not too worried about that high deductible. :-)

Also ... we have a Health Savings Account with $8K in it. We can use that to pay any out-of-pocket medical expenses.

If there were a mechanism like this for property insurance, you can bet we would be using it.

Daniel said...

I like your math here: $2,400 divided by $8,000 is 30%, a *massively* high percentage which fails The Premium/Incremental Liability Rule. Thus you're on the right track to fund that liability yourself rather than pay that kind of percentage rate to an insurance company to protect you from it.


Salixbabylonica said...

Just wanted to write in and thank you in general for these financial posts - please keep them up. I never though I'd be learning so much about financial choices through a food blog, but it's been really refreshing to have your unique perspective and clear explanations.

Daniel said...

Thank you! Agreed that the subject matter is a somewhat of stretch for a food blog, and I'm sure some of these money and personal finance posts bore some readers to tears (that's why I try to warn those readers away with my "friendly warnings" at the beginning of each post).

That said, it's been interesting to see the traffic analytics for these posts. They get at least as much traffic as my food and recipe posts, sometimes a lot more--even though there are always a lot fewer comments.

Once again, thanks for your feedback. I'm glad to see that you're finding value here.


Brittany said...

Ha. Thanks for address my comment in more detail!

"If you don't have the resources to meet a loss, you should insure it." <--This was pretty much the point I was trying to make in discussions on the last article, where the advice was "Drop your insurance coverage! Then put the money in a savings account!" neglecting the time it would take to accumulate enough money to adequately cover the risk. I think this article adequately addressed some of my disappointment with the last article--a lack of discussion of the broader issues that go into making that evaluation.

I still find rental insurance to so dirt cheap (when I have car insurance too, the multi-line discount results in it costing about $.75/month, but even when I'm car-free, it's still worth it) that I still find it's silly not to.

An extension of the Premium/Incremental Liability Rule is "How many years would I have to go without a disaster to break even on the money?" With a loss of $1500 every 8 years, I would be ahead on money with insurance. With a $2500 loss, I'd be ahead every 7 years. I'd put my total value of possessions maybe around $7000-$8000. (Seriously, $2500 for a whole house? Do you not own appliances and furniture?) A half-my-possession lost every 20 years would still be breakeven with having insurance. (And this is neglecting the fact that if I'm keeping this kind of reserve as a hedge against an emergency tomorrow, it would be in a cash-equivalent account making hardly any interest, whereas if I have more insurance, I can have a lower cash emergency fund and invest this money more aggressively for a higher return.)

I'm not saying it never makes sense for forgo insurance if you have the cash to cover it (Warren Buffet, etc.), but I think "tolerance for risk" + cost of insurance is reasonable. And it still comes down on the side of having rental insurance for me when it's dirt cheap. I think it is reasonable to assume I will have a loss every couple of years, because life happens.

Brittany said...

And thanks for the clarification, ChaCha. It's also interesting to see "consumption of insurance v. what you've used" was a major part of your decision to reduce your health coverage, since this is still the element missing from Daniel's discussion, I think. For me, the retail vale of the health care I've consumed in the last year is in excess of $2400. So even though it "fails" Daniel's percentage test, it's still would be a no-brainer for me to pay for better health care coverage.

Daniel said...

I'm happy to have the conversation Brittany. I want readers to disagree with me and tell me why: that gives us all an opportunity to learn.

Keep in mind not every post can cover everything, otherwise my posts would all be 10,000 words long and totally bore readers to death.

Further, the numbers I use and the advice I give are by definition generalized. In other words, I want readers to consider insurance from a different perspective, not get wrapped around the axle when the specific numbers used in the examples don't apply to them. You have to plug in your own numbers and reach your own conclusions. :)

Once again, I cannot possibly know the specific situation of every reader--I'm merely sharing a different way to think about insurance.