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.
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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.

tl;dr:
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

How can I support Casual Kitchen?
For those readers interested in supporting Casual Kitchen, the easiest way is to do so is to do all your shopping at Amazon.com via the links on this site. You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.

Money Sundays: Is All That Insurance Really Worth It To You?

Warning to readers: if you happen to sell insurance or work in the insurance industry, don't read this. It will just make you mad.
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From a comment from long-time reader Chacha:

My total insurance bill (renter's, health, life, and auto) is nearly $1000/mo for a family of two healthy adults in a rental household with paid-off cars.

We have the highest-possible deductibles that our company will allow on renter's and auto. We have multiple discounts etc for safe driver, secure parking, low mileage, etc. Our cars are 1996 and 1999 models - hardly high theft risk - and neither of us has ever caused an accident.

But we live in Beverly Hills, CA, and that alone apparently doubles the premiums (it's far worse of an inflation factor than we've found applied to rent).

For those readers interested in reducing the money they spend on insurance, here are a few things to consider:

1) Save up in your regular savings account the difference before your prior, lower deductible and your current, higher deductible. Then, jack up your deductibles, exactly as Chacha did.

For example, if you are carrying a deductible of $250 on your auto collision and comprehensive policy, increase it to $1,000, as soon as you've saved up an extra $750 (the difference between the two deductible levels) in your savings account. In other words, you will use your own savings to "self-insure" your first $1,000 of potential liability, rather than paying through the nose to an insurance company to do it for you.

Hiking your deductibles usually results in compelling savings. Making a change from $250 to $1000, for example, could save you some $150 a year in premium costs every year (your mileage may vary). And the way to think about that $150 in premium savings is to see it as a permanent, tax-free 20% annual return on the incremental $750 you're holding in your savings account. Not too shabby!

2) Don't bother carrying collision and comprehensive insurance on older, paid-off cars. Remember, in the event of a loss, the insurance company will only pay up to the blue-book value of your car. After 14 or more years (Chacha's cars are 14 and 17 years old respectively), even expensive cars will have depreciated down to just a few thousand dollars. This is an asset that you can far more cheaply self-insure with personal savings.

Thus, you should save up a few thousand extra dollars in your savings account, and view that as your collision and comprehensive "insurance policy." Then you won't have to pay money every year to some dumb insurance company. If this step sounds a little bit like step 1, it is--except in this case you are relying on your personal savings to protect you entirely from a risk, rather than using your savings to cover the difference between a low and a high deductible.

An aside: if you've read my series on Your Money Or Your Life and you're pursuing your personal road to greater financial independence, you'll find that as you build your savings cushion into thousands--or tens of thousands--of dollars, you can dramatically increase deductibles and significantly reduce all of your insurance needs. You'll be able to save hundreds, if not thousands, of dollars in annual premiums.

3) Now, with regard to your legally required auto liability insurance, consider carrying the minimum amount required by your state combined with the highest deductible possible. These steps will save you big time on your insurance costs.

4) Let's move on to renter's insurance. Two thoughts: First, do you really have valuables that are valuable in the monetary sense, or are they just valuable in the sentimental sense? Insurance companies can only give you money... they can't actually reverse time and miraculously replace your stuff.

And if that thought didn't sufficiently bake your noodle, how about this one: How much value do you really get out of having expensive stuff if you're also stuck paying still more to insure yourself from losing it? Roll this over in your mind and you may decide renter's insurance has no value at all.

5) Life insurance. Under what circumstances, really, should you carry it?

You can make an easy case for purchasing life insurance if your household depends on a primary breadwinner. For example, if you're the primary earner in a one-income household with small children, you're probably a good candidate for a policy.

In this case, however, you should only buy a basic term life policy. Avoid fancy "universal life" type policies which wrap investments, variable annuities, etc., around a life insurance policy. These types of financial products are fabulously lucrative for insurance agents and insurance companies, but their value to consumers is dubious. They can be complex, hard to understand, and they can contain disturbingly high investment fees.

Furthermore, as good as they are at collecting your premium payments, insurance companies are often surprisingly mediocre at investing. I make this statement based on my own professional investing experience at an unimaginably large insurance company that, in 2008, went through an unimaginably embarrassing bankruptcy.

As the old saying goes: buy term and invest the difference. Get a simple, competitive, inexpensive, plain-vanilla term policy, and invest the savings in premiums yourself. You'll save on fees, your money will be in your own hands--and you'll probably enjoy superior investment returns.

Of course, if your circumstances allow for it, don't pay for life insurance at all. For example, a two-income household with no children shouldn't need life insurance. Without kids and with both spouses working, what is a life insurance policy really for? Who is it for?

Conclusions
A final word. Insurance is a product that, typically, is both sold and bought emotionally. At its core essence, it is a product designed to (try to) protect you from your fears. Therefore, it shouldn't be a surprise that the people who sell insurance want you to see and feel your fears as much as they can.

Don't let yourself be goaded into carrying water for the insurance industry. Be sure you really need insurance before you buy it, and be sure your need is economic one, not an emotional one. Remember, an insurance company can only give you money in the event of a loss--it can't give you back your car, your stuff or your loved ones.

The counterintuitive ideas on insurance here may already be obvious you. If so, great. But for many people these ideas are far from obvious. If you know someone who could benefit by reading this post, please forward it to them. You might help a friend or family member save many tens of thousands of dollars over the course of their lives.

tl;dr:
1) Jack up all your deductibles and reap the savings on premiums.
2) Ditch collision and comprehensive on any car that's old. Instead, self-insure with your savings.
3) Carry the minimum liability insurance required in your state.
4) Don't own expensive stuff and you won't need renter's insurance in the first place.
5) With life insurance, don't buy it based on fear. Buy it only if you need it, and then get only a simple term policy. Buy term and invest the difference.

Sometimes insurance is necessary. Don't get me wrong. But insurance also quite often fulfills our emotional needs at the expense of our financial needs. As you continue on your road towards financial independence, you'll most likely find you need very little of the insurance you once thought you did.


Related Posts:
Becoming a Knowledgeable and Sophisticated Investor: Six Tips
What Is a Scarcity Mindset? Investing and Living In a Zero Sum Paradigm
How To Make the Tax Code Work For YOU
Is Looking For Tax-Efficient Investments Icky? Or Intelligent?
On Timeshares, Beware
Extreme Savings


How can I support Casual Kitchen?
For those readers interested in supporting Casual Kitchen, the easiest way is to do so is to do all your shopping at Amazon.com via the links on this site. You can also link to me or subscribe to my RSS feed. Finally, consider sharing this article, or any other article you particularly enjoyed here, to Facebook, Twitter (follow me @danielckoontz!) or to bookmarking sites like reddit, digg or stumbleupon. I'm deeply grateful to my readers for their ongoing support.