36

Insurance companies are businesses and their goal is to make money. It follows that if you are neither lucky nor unlucky, you will end up in the long run losing money by stipulating an insurance. I think this is a very simple concept that cannot be disputed, even though every time I try to explain this the other person starts saying how their mom/friend/aunt/etc saved a lot of money by buying insurance.

Now, it seems to me that insurance makes sense only if you cannot recover from a loss without it; for example, if you are a taxi driver with little to no savings it would make sense insuring your taxi against theft, because if you lose your taxi then you are pretty much screwed.

But why do rich people do it too? For example, a friend of mine who has tons of money saved up, insured his car for $1400, 4% of the value of the car, each year. According to a website I found much less than 0.25% of new vehicles are stolen during their lifetime, and in almost all occurrences the thief had access to the original key.

This person could buy another car at any moment without any money problems, so I don't really see any point in insuring, especially with such a ridiculously high price compared to the extremely low risk.

Why do people do it? It's just like gambling, but reversed. If you go to the casino long enough you'll lose money; if you insure long enough, you also lose money.

  • 6
    I think your premise is flawed. You are not guaranteed to lose money buying insurance just because insurance companies are profitable. Insurance companies make money in aggregate, not necessarily on every customer. – JohnFx May 15 '11 at 21:26
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    Insurance companies also profit from earnings on their investments -- the money paid in from premiums is invested in various ways. – bstpierre May 15 '11 at 22:03
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    @JohnFx: I never claimed that. I specified several times "long enough", "neither lucky nor unlucky", etc. – Thomas Bonini May 15 '11 at 22:09
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    Collective insurances, such as government-run health, disability, or unemployment insurances, are based on, among other things, solidarity. See also group insurance. – gerrit Apr 28 '14 at 22:21
  • If the wording was "what are the pros and cons of buying [some kind of] insurance", I would say it's on topic, but likely a duplicate. As worded it is too broad, and not really about personal finance. – NL - Apologize to Monica Nov 3 '16 at 16:11

11 Answers 11

37

There are a couple of reasons that a person might choose to use insurance even if they could handle the financial loss if something went wrong.

  1. They know their risk better than the insurance company. While it might seem odd at first glance that an individual can be better at assessing risk than a large company with thousands of actuaries. There are limits to the amount of knowledge that an insurance company can have or use to price their insurance products. For instance if you were a very aggressive driver but didn't have any recent tickets or accidents because you were in college and didn't have a car on a regular basis, but now you have a job and drive 30 miles to work every day. You know your risk is relatively high but the insurance company sees you as relatively low risk and aren't able to price that extra risk into your premium.

  2. Just because a person can survive financial after losing something like a car or a house doesn't mean it isn't desirable to pay a small price to mitigate that risk. If you are using your savings to pay for an emergency then that money needs to be semi liquid in case you need it limiting your investment options. Where as if you purchase insurance you pay a small amount of money to be able to invest the rest of your money. Liquidity is a big deal particularly if you are a small business and investing into your business where your money can make your more money but you may or may not be able to access that money very easily.

  • 12
    +1 for the second point. The value isn't always limited to the cash value, sometimes the value is the peace of mind. – MrChrister May 15 '11 at 18:23
  • I disagree with the claim that the self-insured money should be parked in a liquid or semi-liquid investment. Not if it's much smaller than the size of your corpus. Then, if disaster strikes, you know you can withdraw the money from your long-term equity investments, even if the market is significantly down, without decimating your corpus. No need to suffer from the lower returns liquid or semi-liquid investments give you. – Vaddadi Kartick Oct 11 '16 at 16:45
17

For a car, you're typically compelled to carry insurance, and picking up "comprehensive" coverage (fire, theft, act of god) is normally cheap. If the car was purchased with a loan, the lender will stipulate that you carry comprehensive and collision insurance.

People buy insurance because it limits their liability. In the grand scheme of things, pricing in a fixed rate of loss every year (insurance premium + potential deductible) is appealing to many versus having to cover a catastrophic loss when your car is wrecked or stolen.

  • This is also why people buy health insurance even if they're capable of covering their medical expenses out of pocket - you are legally required to pay for health insurance (in the United States) and if you do not, you have to pay a tax penalty once a year - usually it is cheaper to just purchase the insurance and use it to cover medical expenses throughout the year. – Zibbobz Mar 11 at 19:35
13

Your basic point is correct; the savvy move is to use insurance only to cover losses that would be painful or catastrophic for you. Otherwise, self-insure.

In the specific example of car insurance, you may be missing that it doesn't only cover replacement of the car, it also covers liability, which is a hundreds-of-thousands-of-dollars risk. The liability coverage may well be legally required; it may also be required as a base layer if you want to get a separate umbrella policy up to millions in liability. So you have to be very rich before this insurance stops making sense.

In the US at least you can certainly buy car insurance that doesn't cover loss of the car, or that has a high deductible. And in fact, if you can afford to self-insure up to a high deductible, on average as you say that should be a good idea.

Same is true of most kinds of insurance, a high deductible is best as long as you can afford it, unless you know you'll probably file a claim. (Health insurance in particular is weird in many ways, and one is that you often can estimate whether you'll have claims.)

On our auto policy, the liability and uninsured motorist coverage is about 60% of the cost while damage to the car coverage is 40%. I'm sure this varies a lot depending on the value of your cars and how much you drive and driving record, etc. On an aging car the coverage for the car itself should get cheaper and cheaper since the car is worth less, while liability coverage would not necessarily get cheaper.

  • 2
    I would like to add a clarification: having liability coverage does not protect you from hundreds of thousands in risk, due to risk limits that people don't always understand. In the US this is typically 25k/50k (per incident/policy lifetime limit), or as much as 100k in some cases - but beyond that the insurance company offers no protection at all. Thus the use of an umbrella policy, as you mentioned - so it's clear you understand it, but all too often people think "having insurance" protects them from massive loss even when it doesn't. – BrianH Aug 13 '14 at 16:00
  • @BrianHall: To be clear, the numbers you give are in line with many state minimums for liability coverage, but most car insurance companies do push higher coverage limits (commonly 250K/500K/100K for per person/per incident person cap/per incident property damage), and the incremental cost of the higher coverage is often much less than the cost of the basic coverage (it's not paid out often, and electing it demonstrates responsibility, which they like in their insured). Beyond that, you're usually not eligible for umbrella insurance unless you've maxed out the auto policy coverage. – ShadowRanger Jan 10 '18 at 16:21
8

All investors have ultimately the same investment goal: maximize returns while limiting risk to an acceptable level. Of course we would love to maximize returns while minimizing risk, but in most cases if you want higher returns you must be willing to accept higher levels of risk. We must keep in mind that investors are humans, not computers. As such not everybody is willing to accept the same level of risk.

Insurance is simply a way to "buy down" risk. Yes, it reduces our overall gains (most of the time), but so do bonds vs stocks (most of the time). And yet who among us doesn't have bonds in our portfolio? Insurance is yet another way to balance risk and return.

4

Insurance isn't a product designed to protect against financial loss. The product is designed to allow people to pay a small fee (the premium) for peace of mind. This allows the insured to feel as if their purchase was worthy (they see the potential of loss as a concern and the premiums small enough to allow them to not worry about having a loss).

Insurance companies will then seek out insurable risks where the perceived losses far out weight the actual losses (risk assessment).

So, you answer is that your friends are paying for peace of mind.

  • Insurance started out as a means of pooling risk. I.e. it was exactly what the OP clearly expects it to still be. If there's 1 chance in a million of me having an accident that will cost me $1 million - which will leave me hopelessly in debt for the rest of my life, and my chance of this happening is independent of anyone else's chance, it's a great idea for me to get together with millions of other people facing the same risk, and each contribute $1 to paying the costs for whoever it happens to. – Arlie Stephens Nov 3 '16 at 1:32
  • It's even a good deal for a middleman to offer to cover that risk for $2 each, and pocket half the money collected as profit (or to pay for their salesmen, or to cover the possibility that the real odds are only 1 in 900,000). The same thing is true, with more complex math, if the average is the same, but not identical each time the problem occurs - sometimes it's "only" 750,000, and sometimes it's 1,250,000. – Arlie Stephens Nov 3 '16 at 1:32
  • These days though, most insurance has a ceiling, so you can't actually buy protection against the most extreme possibilities. Medical and long-term-care insurance seem to be the worst offenders here, at least in the US. And that changes everything. – Arlie Stephens Nov 3 '16 at 1:35
4

Insurance is a funny product. As you said, it is a little like gambling. When I buy term life insurance, I'm essentially betting that I'm going to die within the next 20 years, and the insurance company is betting that I'm not. I'm hoping to lose that bet!

Besides all of the reasons that other answers mentioned, I think part of the reason is psychological. As in my example, I'm setting up a kind of a win-win situation for myself here. Let's go with car insurance, a less-morbid example than my first example. If I don't get into a car accident, great! If I do get into a car accident, then the traumatic event is at least offset by the fact that the financial impact to me is minimal. Win-win.

  • It makes sense to me more clearly than the other answers. – user 31466 Feb 9 '15 at 8:52
  • But one thing i have not understood in term life insurance is that, are they set a time period to pay as you mentioned about 20 year time interval. – user 31466 Feb 9 '15 at 8:56
  • @Leaf When you buy a term life insurance policy, you decide what the term will be. (10, 20, 30 years, etc.) The insurance company will then decide how much you need to pay, based on the likelihood of death within that time period. – Ben Miller - Reinstate Monica Feb 9 '15 at 14:44
  • So if one decide the term is 10 years and starts to give premium and after 10 year s/he is still alive, then does s/he lose all money ? – user 31466 Feb 9 '15 at 14:49
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    @Leaf Yes, essentially. It is the same as car insurance, homeowners insurance, etc. If you pay the premium for 6 months of car insurance and you don't crash your car in 6 months, then you don't get your money back. – Ben Miller - Reinstate Monica Feb 9 '15 at 14:52
4

Ignoring that liability car insurance is usually a state mandated requirement and that all banks require full coverage, there are quite a few reasons to buy it.

No matter how much money you have, you can't really guarantee that you can recover financially from an accident. Yes, you can buy a new car. But what happens if you are sued because the other driver died or is now in a long term coma? The legal costs alone would financially bury most people.

It's even worse if you are rich. Let's say someone rear ended you. If you had no insurance (again ignoring the legality here), you can bet their attorney would take a look at your considerable financial assets and do whatever it took to get as much of that as possible. The legal fees alone of defending yourself at trial would likely far outstrip everything else.

And that's just one little situation.

  • If the other driver died, will car insurance company give the financial compensation? – user 31466 Feb 9 '15 at 10:18
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    Liability insurance is not federally mandated. Requirements vary by state. In New Hampshire, it's not required at all. – Brythan Nov 3 '16 at 2:56
  • @Brythan: fair enough. I've updated the answer – NotMe Nov 3 '16 at 13:44
0

In addition to stoj's two good points I'll add a couple more reasons:

3) In some situations there are secondary factors involved that can make it a good deal. These normally amount to cases where you can buy the insurance with pre-tax dollars but would have to pay the bills with post-tax dollars.

4) Insurance companies know much better what things should cost and often have negotiated rates. A rich person would generally be well-served to have health insurance for this very reason.

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    Your premise on health insurance is extremely flawed. Doctors much prefer cash pay clients than insurance ones even at the same fee. Quite frankly, it costs them far less to actually get paid. For this reason most doctors will happily negotiate a lower fee for services with you if you are paying cash. – NotMe Aug 13 '14 at 1:04
  • It depends on the doctor, and the situation. My experience is that in the US, health "insurance" is primarily a case of huge insurance companies using their size as leverage to demand lower rates from providers. Secondarily, the "insurers" are using their near-monopoly power to deny certain treatments to the insured end-user. Thirdly, the "insurers" use their massive bureaucracies to "lose" claims etc. in the unstated expectation that a certain number of end-users and health care providers won't successfully challenge the bureaucratic "error," thus reducing the insurer's costs. – Arlie Stephens Nov 3 '16 at 1:16
  • Sometimes the provider is able/willing to charge the same amount to non-insurance clients, thereby saving themselves the bureaucratic costs, and still feeling adequately compensated. But it seems equally common that the provider doesn't feel they can make an adequate income at that "negotiated" (i.e. insurance company imposed) price, and therefore charges non-insured customers significantly more. Some people buy medical "insurance" simply to get the "negotiated" prices. – Arlie Stephens Nov 3 '16 at 1:22
  • @ArlieStephens You probably can negotiate a good deal with your doctor. Don't expect to fare nearly so well with the specialist. I've had to negotiate a set of bills--I had the EOBs for everything, it's just the insurance didn't pay. Every routine doctor accepted the EOB amounts on the first call. Only one place that isn't one you normally choose to go to would accept the EOB amount, though. They all had cash prices that were at least 20% higher. – Loren Pechtel Nov 3 '16 at 3:50
0

You're making the assumption that a person would be aware, in advance, that they'd have enough resources to pay the costs of anything that might happen.

Second, you're assuming the cost of insurance would outweigh what the person would have to pay out of pocket if they didn't have insurance. In other words as an example, if the insurance premiums on my car are so high that it would be cheaper for me to replace it myself in cash then it might make sense, but how likely is that to be the case?

There's a gambling adage that I think applies here - "Always bet with the house's money". Why would I put my own money on the line in the event of some event rather than pay for an insurance policy that takes care of it for me? That way, my costs are predictable and manageable - I pay the premiums and perhaps a deductible, and that's it.

0

But why do rich people do it too?

Because they've got "deep pockets", and thus tend to get sued more frequently and for larger amounts.

Therefore they need more insurance than "regular people".

-2

This person could buy another car at any moment without any money problems, so I don't really see any point in insuring, especially with such a ridiculously high price compared to the extremely low risk.

Convenience. If you self-insure, then an accident means that you have to make arrangements to get the car towed, fixed, evaluated, etc. If you buy insurance, your insurer would prefer to do all that. They argue with the mechanic over prices, the lawyer over liability, etc.

And of course, rich people need more liability insurance than other people, not less. So part of that $1400 is probably money that your friend would have to pay regardless.

  • If you are rich enough to self insure then one phone call to your personal assistant gets your car towed, fixed, evaluated etc. – DJClayworth Mar 11 at 3:07
  • @DJClayworth The cost of self-insuring in terms of the question is the price of a car. So the person has an emergency fund of, say, $40,000. That could buy a personal assistant with a $30,000 salary for one year (the remaining $10,000 is for employment taxes, etc.). But what about the second year? You are conflating wealth with income. It's easy to have sufficient wealth to afford a new car. Enough income to afford an assistant is a much higher bar. Why? Because an assistant's cost is every year. The new car that insurance would buy is a one time event. – Brythan Mar 11 at 9:35

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