April 15, 2024
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April 15, 2024
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Self-Insurance: Done Best by… Insurance Companies

Self-insurance is one of those magic phrases that grabs your attention. It implies “shortcuts” and “cost savings” and “what they don’t want you to know.” For those who believe every financial institution is part of a global conspiracy, self-insurance is your chance to stick it to the man.

The concept of self-insurance is simple: instead of paying premiums to an insurance company, you systematically set aside a pool of money to be used if an unexpected loss occurs. If the house burns down or the car is totaled, you don’t file a claim, but use the accumulated funds to replace it.

For the do-it-yourself financial gurus, self-insurance is often a recommended strategy. Here’s a statement from a software developer who retired at 50, and now blogs his financial insights:

(T)he short answer to the question “When should you self-insure?” is “Whenever you can.” Remember that insurance is generally a business, run at a profit. That means that whenever you can reasonably self-insure, you will also turn a profit. You’ll come out ahead in the long run.

Notice the walk-back statement: whenever you can. Which, after further examination, turns out to be, not very often. In fact, the rest of the article is a fairly comprehensive argument that while self-insuring might sound attractive, it’s not practical. Instead, the commentary ends up making a strong argument for using insurance companies. Here’s a bit of what follows:

(B)efore you cancel all your policies, and put yourself or loved ones at risk, do ask yourself some tough questions:

  1. Will you be “in business” to pay a claim? This is why you can’t self-insure for life (or disability) insurance, at least not as long as you have dependents relying on you for income. If they need you to be alive and working to put bread on the table, then part of caring for them is buying enough insurance so they are not destitute should you pass from the scene.
  2. It’s not enough just to be “in business” (alive). Could you afford to pay a claim from your liquid assets? You’ve got to have the cash flow to make good, without taking losses elsewhere. That’s why most people can’t self-insure their home (even though the chances of losing a home to a house fire are miniscule) or health care.

Does this sound like an argument for self-insurance? Actually, it sounds like basic information from an insurance agent on why it makes sense to buy insurance. The writer says some self-insurance might be effected by reducing coverage amounts, changing waiting periods or increasing deductibles. But the necessity of being in business/alive and having sufficient liquid assets pretty much negates the self-insurance concept for life, disability, health and home protection.

While noting liability insurance protection is required by law, the author does see self-insuring potential for the replacement of an automobile. But to do that…

You must keep $5,000-$10,000-$15,000, or whatever you think you’d need to pick up some reliable used transportation on short notice, available in an insured savings account or low-volatility investment.

After which, he immediately concedes…

And I’ll guess that’s where most people get cold feet and decide to pay an insurance premium instead: it’s a lot of cash to part with all at once.

…Which is another argument for using an insurance company to protect your assets. Paying out of pocket substantially reduces liquidity in the moment (and what happens if you have another loss soon after?) and incurs an opportunity cost—you forego what could have been earned if the money remained invested. By using insurance, your liquidity needs are lower, and more assets can be allocated to higher-yield options.

After acknowledging that self-insurance isn’t workable for the big financial risks many consumers face, the author further reinforces the superiority of the insurance company model, i.e., pooling assets to spread the risk of loss over a large number of people.

How likely is a claim? Insurance companies have the data and the business volume to answer this question very precisely, and that’s why they can run highly profitable businesses under conditions where we, as individuals, cannot.

To make self-insurance work, you need to insure more than one asset. Insurance works because the accumulated reserves cover multiple lives, cars, homes, etc. When you are attempting to exclusively insure just your life, your income, your home, there is no spreading of the risk.

The author claims there may be circumstances where our knowledge about a particular risk may be better than the insurance company’s. In his situation, he sees his son as a very responsible teen-aged driver of an old, high-mileage, used car. Self-insuring a vehicle whose replacement value is marginal may make sense, but the savings are minimal. You may “turn a profit” by self-insuring, but it isn’t a very big business.

This article on self-insurance ends with an ironic twist. Remember, the writer is a former software developer:

I’ll admit there is one area where I’ve always found it easy to justify a service contract: my computers. Access to a functioning computer has been critical to my livelihood ever since the start of my career. Being down, even for a few hours, is guaranteed to produce frustration, and possibly even loss of income. I’ve never had a problem paying a few hundred dollars annually to avoid that…Insuring my computers is essentially a business decision.

The replacement cost of a computer, even a really good one, probably isn’t as much as a car, a home, or annual medical bills. If anything might be a candidate for self-insurance, it’s a relatively low-ticket item like a computer. But for his really important assets, the author doesn’t self-insure. And really, that’s the same for everyone.

By Elozor M. Preil

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