Wednesday, February 3, 2016

The Way I Think about Insurance

There are a tremendous number of different types of insurance. It can be difficult sometimes to decide which types to buy. Here I describe the way I think about insurance and how it guides my choices. I encourage my readers to come up with their own ideas to guide them when it comes to insurance.

The core of my thinking about insurance is that it is a way to protect myself and my family from low-probability events whose costs would be devastating to our finances. This means I specifically exclude high-probability events and low-cost events.

An example of a high probability event is needing dental work. As it happens, my employer gives me “insurance” to cover this, but I don’t consider it insurance because it is capped at a low level. It’s just extra pay because it’s not protecting me against a large loss.

After I retire, I would never buy typical dental or health insurance. Insurance companies employ smart people. They would never let me buy coverage that costs less than the expected benefits I would get. They’d also add extra to the cost for their own overhead and profits. I’ll be better off just paying directly for dental work. If I could get insurance that covered high-cost dental work or health costs, that could be useful to me.

An example of a low-cost event is when some consumer item like a television breaks. I never buy extended warranties. For one thing, retailers often find a way to avoiding honouring them. But, even if retailers did honour warranties, I wouldn’t buy them because I can afford to replace a broken item. I was once even offered an extended warranty on a $5 battery! What a waste of time.

So, what kinds of insurance make sense? Liability insurance for your car and home come to mind first. Getting sued for a couple of million dollars would certainly be devastating for almost all of us.

Insurance against damage to my home also makes sense. I wouldn’t want to have to pay for a rebuild if my house burned down. However, I choose a very high deductible. I wouldn’t make a small claim anyway, so paying a higher premium for a low deductible makes no sense. The same applies to deductibles for collision insurance on cars. I don’t even bother with collision insurance on my car once it’s worth less than $10,000, but I do keep the liability insurance.

Life insurance makes sense to protect anyone who depends on your income. However, I look for the cheapest term life insurance I can find that has the term length I need and is convertible and renewable. I’m not interested in the various forms of permanent insurance such as whole life and universal life because they just bolt an expensive investment component on top of term life insurance.

Disability insurance makes sense as well. Most of us are more likely to become disabled than we are to die. However, this is a tricky area. It can be difficult to determine whether a plan has reasonable coverage for its cost.

Many of us have various types of insurance through our employers. Health insurance is just extra pay because it won’t pay for anything truly expensive. Disability insurance through an employer can work well, but life insurance may not. If you get cancer and decide you don’t want to spend your last reasonably healthy days working, you may find it difficult to convert your employer life insurance to an individual plan because you’ve become uninsurable. Some employer plans offer convertibility, but there are deadlines and the insurance company is motivated to make such a conversion difficult for anyone with an elevated chance of dying.

I never link insurance to a financial product like a mortgage or credit card. Few people realize that the underwriting for mortgage life insurance doesn’t take place until there is a claim. This means the insurance company doesn’t check whether you’re covered until you die. You can bet they’re willing to put some effort into finding a reason to deny your coverage.

So, there you have my personal philosophy on insurance. I look for ways to protect my finances from devastating losses. I ignore all forms of insurance that cover losses I can handle. Your mileage may vary.

25 comments:

  1. Good Morning Michael;
    We think pretty much the same way for insurance.
    I dumped life insurance once the "kids" were employed. Now all I have are a couple of "paid up" policies of low value but sufficient to get me in the ground so to say. If there is any money left in the RRSP/RIF/TFSA that will be their inheritance along with the house if I still own it.
    I did take out life insurance policies for the kids when they are young and those are paid off. Kind of a present to them in that they do not have to buy one themselves. Having said that the "high" valus insurance I bought is not all that high anymore. Rack that up to inflation, or in this case deflation.
    Keep the house and car insurance with the same reasoning.
    I got robbed once ad claimed. What i learned from this is that you almost never know what they walked out with. You will find out latter when you are looking for something and can not find it. Try to claim that two months after the fact. I also found out the adjuster will just about contest any value you put on something so that they do not have to pay out too much. OH! And that insurance policy that you have diligently paid for all those years. Well the payments will increase after a claim. After all, the company is really in the business to make money. You claim is a distraction for them and you need to pay fo rthat.

    RICARDO

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  2. @Ricardo: As long as there is nobody left who depends on your income, getting rid of life insurance makes sense. I'm not a fan of any type of life insurance policy that combines investments (paid-up policies, etc.). Unless a child has a substantial income, I don't see the logic of getting life insurance on a child. I've heard of many people having trouble with insurance companies trying to get compensated for destroyed items in their houses.

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  3. Same approach.

    A couple of weeks ago had a bit of an argument with an insurance broker. She wanted me to take collision coverage for the cars rather than just liability. I told her it's not something we would be likely to use, even if there was a collision. And it's something we can cover ourselves. She basically told me I was stupid. Oh well...

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    1. @BHCh: I guess "stupid" is defined as not putting money in her pocket.

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    2. She probably just got overemotional because she wanted me to be protected SO MUCH. Did as directed in the end.

      Ontario car insurance in general is a racket. I am comparing to UK, where the service is way better for much lower costs. Assume it's a combination of bad laws, bad driving, having a relatively small market and lack of effective competition.

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  4. But, as Chris Rock points out, (from Bigger and Blacker):

    You know what's worse than taxes?

    What's worse than tax is insurance.
    You got to have some insurance.
    They shouldn't even call it insurance.
    They just should call it ''in case sh*t.''
    I give a company some money
    in case sh*t happens.
    Now, if sh*t don't happen,
    shouldn't I get my money back?"

    Seems to agree with your perspective, doesn't it?

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    1. @Big Cajun Man: Chris Rock is a very funny guy, but I'm afraid the math doesn't add up for his take on insurance.

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  5. That's a great take on insurance. Particularly the take on health and dental insurance and disability insurance. Disability insurance should have a much higher priority than most consumers realize, and health and dental should have a lot less priority than most people realize.


    There's one inconsistency in your post. The expected value of insurance is always less than the premiums you pay. That's actually not true - there's a variety of instances where expected value is greater than sum of your premiums plus interest.

    With permanent/whole life insurance, lifeco's know that a certain percentage of people will cancel before dying. Those people pay premiums but don't get a benefit, and help keep premiums down (thanks BTW). I ran a case a couple of weeks ago where a 70-odd year old had a pre-tax rate of return of 7.9% guaranteed at his expected age at death for a whole life policy. It's absolutely a good financial planning vehicle - for people that don't need access to the cash while they're alive. Which granted, isn't most people.


    For health and dental, there are potential tax deductions that can offset the cost of these coverages. In fact when I ran our numbers years ago, it was a break even between our claims, premiums and tax deduction. I ended up buying catastrophic (high end coverage) only and we self-insure our routine health costs but for someone who wants to fix and budget these monthly costs there's potentially no real cost.

    Of course most Canadians have become accustomed to the idea that they 'must have health and dental insurance' to cover their fillings, but in practice, these costs are painful but not catastrophic.

    Anyway, just clarifying for the more analytical reader. In practice, everything about your post is the actual advice most consumers should take.

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    1. @Glenn: Thanks. On the subject of exploiting those who cash in permanent life insurance before death, I've never seen a case where the numbers worked out as you describe, but I've only looked at a few cases. I'm happy to crunch the numbers with any data I get. One thing for people to keep in mind, though, is that they shouldn't underestimate the odds that they will have to cash in early as well.

      The last I checked, the deductibility of health and dental premiums was the same as deductibility of health and dental payments (for individuals). Maybe you're talking about things you can do through a corporation?

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    2. Michael, the numbers start to work out on permanent insurance as an investment under a couple of conditions:
      1) you don't need the money during your lifetime i.e. you have enough assets to last for you, plus your inheritence, plus some extra. Because this works only if you don't cancel. So only using funds you don't need while alive.
      2) you're in a higher tax bracket.
      3) You want a portion of your investments to be fully guaranteed.

      So in other words, it works well for those who are more affluent. And yes, it works great if you've got $50k for 10 years to throw at this.

      The tears start when the industry starts touting the benefits to people that don't meet those initial criteria.

      So yeah, You're correct for readers, and I'm being 'technically correct' :). Again, a great article on insurance, well worth the read.

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  6. I kind of chuckled when I read, "Most of us are more likely to become disabled than we are to die." Pretty sure all of us are likely to die, and only some of us are likely to become disabled. ;)

    I am sure you did not mean it the way I read it...

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    1. I read it as [during the term of the insurance].

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    2. @Garth: I could have phrased that better. But I meant during your working life.

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  7. "Insurance against damage to my home also makes sense. I wouldn’t want to have to pay for a rebuild if my house burned down.

    Life insurance makes sense to protect anyone who depends on your income.

    Disability insurance makes sense as well. Most of us are more likely to become disabled than we are to die."

    I recently posed to a financial professional as to why there is no straight up portfolio insurance available (as opposed to resorting to using options). He gave an oblique type of answer that was not all that satisfying. Perhaps MJ readers can offer some thoughts and ideas.

    "The core of my thinking about insurance is that it is a way to protect myself and my family from low-probability events whose costs would be devastating to our finances."
    A 50-60% drop in portfolio value would be low-probability as well as possibly devastating to your finances. Other low-probability/surprise/Black Swan events such as the Halloween Massacre permanently wiped out a lot of wealth and income for a lot of Canadians.

    "This means I specifically exclude high-probability events and low-cost events."
    A 10% correction in public equity markets is a high-probability event, thus no need for coverage.

    Think of your portfolio like a car. I can buy the safest car around (low-risk portfolio) and be the best darn driver on the road (non-emotional, logical), yet I still have to drive on the road (financial markets) with all the other drivers (market participants) to reach my destination (retirement, etc.).

    If I can get insurance on my assets -- house, car, human capital/income, etc. -- against things that are not of my fault (e.g. rear end collision is the #1 auto claim), then how come I can't buy insurance for my financial assets against no-fault events (e.g. fraudulent Big Banks)?

    Let's go with that for now. Thanks.

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    1. You can get insurance on your portfolio. It's called a seg fund. The seg fund insurance on the portfolio guarantees 100% of deposits after 15 years, or at death.

      Unfortunately the cost of that insurance isn't worth paying for almost anyone. And really never for anyone who's reasonably well informed.

      I've spoken to an insurance company about the high cost of seg funds and was told not to expect the prices to come down in my lifetime.

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    2. @SST: Any form of portfolio insurance offered by an insurance company is almost certainly going to be more expensive than using options.

      My approach is twofold. While I'm still working, I self-insure by being willing to work longer than anticipated if stocks crash. Before retiring, I will move 5 years of spending into safe assets (e.g., GICs). That way I'll be able to ride out an extended market decline. But because markets have always recovered, I don't consider market declines to be permanent. Anything that causes a permanent market decline could cause a permanent loss of value of dollars as well. I know of no way to insure against such things.

      It's true that a big tax change or massive banking fraud could cause a significant permanent loss, but I know of no way to insure against such things for a reasonable cost.

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    3. Nope. Seg fund is a mutual fund, not an outright insurance policy.

      That's like saying the only form of car insurance is to own a Subaru and no other make of vehicle. I want to drive a Ferrari. And maybe a monster truck (I hear they're cheap in Alberta).

      (With the encroachment of the new fee disclosure regulations, many snakey advisors are pushing seg funds which are not subject to CRM2. Tell me again, Mr. Advisor, why you don't want me to know how much I'm paying/you're making?)

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    4. >Nope. Seg fund is a mutual fund, not an outright insurance policy.

      Nobody said that it was (other than you?)?

      It's an investment vehicle with insurance attached to it. It is certainly NOT a mutual fund. It looks like a mutual fund, it might even track returns of a mutual fund, but it is not a mutual fund. But you know this already.

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  8. Glen, in view of your comment about the high cost of seg funds that isn't worth paying for, I'm curious as to why you would write an article promoting seg funds for RESPs over on "My Own Advisor", and vigorously defend that position in the comments section when readers objected.

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    1. Because it's general advice, not an absolute. And suggesting I vigourously defended it is misleading. The only thing I vigourously defend is having people think about it.

      Here's an article I wrote where I 'vigourously defend' exactly the opposite:
      http://www.dividendearner.com/mutual-funds-vs-seg-funds/

      Check your assumptions and run the numbers.The generalities everyone throws around on the internet do not always apply in the individual case. So someitmes I write articles intended to make people think about situations where the general case may not be true. Which was the point behind the article you referenced. Seg funds, generally a bad idea, but in some cases are a valid choice. That's a statement I'm happy to vigourously defend.

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  9. Ok, fair enough. Glad to hear you are not vigorously defending seg funds. I think there are only very specific and not many instances when combining insurance with investing is a good idea.

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    1. @Grant and @Glenn: I'm always pleased to see an intelligent discussion that stays civil.

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  10. I agree with all this, even though I probably couldn't have stated it so cogently. I recall seeing a show about mortgage insurance and its perils that you refer to. It was "W5" or "Fifth Estate", probably. When we got our mortgage, we had to sign an ominous sounding rejection of mortgage insurance. Something like "I'm insanely rejecting mortgage insurance. May God have mercy on my doomed soul."

    I was just reminded by another article that decent term life insurance coverage is much better than mortgage insurance: less loopholes.

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    1. @Gene: I remember signing a similar mortgage insurance rejection when I renewed my mortgage. Someone less confident in their choice might be intimidated by that little charade.

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