One aspect of becoming financially prudent is mitigating risk. In many cases, our best bet seems to be transferring the financial risk of a negative event to an insurance company.
The problem is that we end up feeling “over-premiumed”; we trade the financial aspect of the risk to the insurance company but gain a premium expense — or a few premium expenses — into our budgets.
The most important things to insure against are those with a large financial cost and a relatively low probability of occurrence. We do this with fire insurance on our homes. It’s a potentially massive cost with relatively low probability; we can’t afford to not have it.
We are mandated to have some types of insurance. Nearly all states require auto insurance for the privilege of driving; the few that don’t require insurance have additional financial requirements instead. No one realistically gets away without auto insurance — with the exception of those who don’t drive.
Our opportunities to forgo insurance without placing excessive risk on our finances appear slim. It seems there has to be a better way. In many cases, at least a partial solution comes from what is commonly referred to as self-insuring.
What Is Self-Insurance?
Self-insurance is actually a misnomer. Insuring involves transferring risk to a third party; keeping the risk yourself is risk retention.
But the financial world and the business world have embraced the idea of prudent risk retention under the name of “self-insurance” and there’s no good reason to fight it. Even if it is not really the case, everyone seems to agree on the concept.
Self-insurance is systematic risk retention with plans for dealing with the financial costs due to the retained risks.
If we simply cancel an insurance policy and retain the risk without a plan to deal with events that would have been covered by insurance, we are not self-insuring.
If we build a fund to pay for expenses that we might incur due to lower levels of insurance, then we are “self-insuring.” We need to address the risk, but do so without purchasing insurance — or not as much insurance — for it to be self-insurance.
The Self-Insurance Opportunity
The biggest opportunity to practice self-insurance is with reductions in insurance coverages, such as with increased deductibles. At least to start.
It would be a bad financial decision to cancel your insurance policies without a specific means of dealing with the potential harms they cover. The opportunity is to move in the direction of less coverage and lower premiums (yeah!) over time.
The big five of insurance coverage for most people, in no specific order, are health insurance, auto insurance, homeowner’s or renter’s insurance, life insurance, and disability insurance.
Not everyone has all five; not everyone needs all five. Many people should have some they currently don’t. But this little list is where most people will find their self-insurance opportunities.
How to Self-Insure: Your First Steps
The most common mistake is to reduce coverage without having a means to pay for an event that would have been covered.
For example, someone may choose to increase their auto deductible even though they have no savings. This puts additional risk on themselves; if they have a claim will likely harm their finances, more than they have helped them.
To begin self-insuring, you need a buffer to pay for expenses that would have been covered. If you’re looking at a small reduction in premium, typical with increasing an auto deductible, it could take many years to build that fund. You will probably need to jumpstart your fund.
Here’s a very effective way to do it — establish an insurance account. You will put all of the money you need to pay your premiums into this account and pay for your coverages out of it.
If you need $100 per week to pay your premiums, have $100 from each weekly paycheck deposited into the account and make all of your premium payments from the account.
Now you have automatic tracking. All of your premium dollars go through one place. Some may come directly out of your check, such as health premiums through your employer, and that’s fine. It won’t mess anything up.
To jumpstart your account, put in a little extra money. Most people work on overfunding their emergency fund to pay for unexpected expenses; perhaps you can take $500 or so from there.
Perhaps you have to build the extra $500 across a couple months, that’s fine too. But you want to get a base where you have enough coming in to pay all of the premiums and you have a $500 buffer.
Now you are in position to increase a deductible by $500. This needs to be analyzed a little first.
Analyzing Insurance Changes
In getting better financially, we often start with baby steps. They’re small, they don’t seem like a lot at the time, but they add up, and they start the ball rolling. To begin self-insuring, our first baby step is often increased deductibles.
We need to look closely at what we are giving up and what we are getting in return. We need to be very cognizant that part of self-insuring is risk retention — we pay less premium but we take more risk.
Let’s say increasing the deductible on your auto policy by $500 reduces your premium by $40 per year. You would need to be accident free, at least at-fault accident free, for over 12 years to break even with a single claim. That’s a long time. Not uncommon, but definitely an increase in risk. Your numbers will vary; you’ll need to check them and use your own.
That’s the dollars part of it. You need to weigh the dollars in context of your situation. If you have teenagers in the house, it might be prudent to hold off on this particular change. If you’re empty nesters, it could be a fair bet.
Any potential change involves a potential cost. If you reduce coverage, you are transferring less financial risk to an insurance company. No other way to do it.
You can shop coverages, look at eliminating or reducing some riders, but any act of self-insurance is also an act of risk acceptance. It should be done carefully and thoughtfully.
You may find you need to increase some coverages. Most people do not have sufficient disability insurance. But if you’re prudent ,you can use your cash reserve to carry you for a period and get a policy with a long elimination period at a much lower premium than a policy that pays right away.
It’s not financially prudent to be over-premiumed, but it’s not financially prudent to be under-insured either.
Risk One More Time
We may have flogged the horse of increased risk a bit much. It’s that important. One thing to consider is the risk of excessive losses. Let’s use auto insurance as our example again.
We looked at a situation in which you could save a little (very little) premium by increasing a deductible. (Reminder: you would need to use your own actual numbers).
In our example, you could have one claim where you paid the deductible in a 12-year period to break even. But you could have multiple claims within a single year.
The chance of excessive losses, multiple claims from one or more policies in a short period of time, is real. It can happen; it does happen.
Claims don’t come all nicely spread out. They just come when they come.
It’s important to understand this. When and if you decide to save some money be self-insuring, you need to be okay with the possibility of it costing you money. In most cases, done thoughtfully and prudently, you come out ahead.
Every once in a while, things don’t work so nicely. You can manage the risks, but you can’t eliminate them.
Other Self-Insurance Opportunities
Warranties are a big one. It seems we are now offered warranties on nearly every durable item we purchase. There’s a reason for this. It’s called profit.
Companies offer warranties on low cost durable products to make money. Very few people will collect under these warranties; most will probably forget they even have it. Certainly some will make use of it, but as a percentage of purchasers it’s a small amount.
Not purchasing warranties on inexpensive items is a great way to self-insure. Add the cost of the warranty to your insurance account and self-insure for the item’s repair or replacement.
If you pay attention, you’ll find that you can tweak your insurances to switch the burden to yourself — slowly and prudently.
If your goal is to continue to move in the direction of further reducing premiums and ultimately self-insuring to the greatest extent practical, you’ll want to have an operational strategy. You’ll need to continue to build the buffer in your insurance account to be able to handle larger costs.
When you save on premiums through coverage reductions, you should continue to put the full premium into the account to build the buffer. It’s still your money, but you’re giving it a purpose.
This allows the buffer fund to build and then you can consider additional changes to bring more risk into your domain and less premium into the insurer’s domain.
There will be limits for each type of insurance. You most likely have mandated minimums for auto insurance, and the liability that’s mandated is typically less than you should have. It’s generally better to focus on the property side of auto and home and keep higher liability coverages.
Health and disability insurances share some similar characteristics in terms of how they fit into our financial plans. It’s nice to have them for the little things but we need them for the big things.
It doesn’t make sense to try to get rid of your health insurance; it’s better to work on reducing your overall cost through increased deductibles, if that is appropriate in your health situation.
Disability insurance has a clear-cut point at which we no longer need it. We should have disability insurance until retirement is affordable and work is optional — we need disability insurance until the point at which we are financially independent. We can still manage the costs beforehand.
We can build our reserves and increase our elimination period or in some cases reduce benefits. But we generally need to have this insurance in place until we are financially independent.
Life insurance has its own peculiarities. Some experts recommend trying to get to the point of self-insuring for life. I don’t recommend that. It can make sense in some instances, but not as a general rule. Life is a different situation. Here’s why.
Mortality is 100 percent. None of us get out of here alive. No other insurance is protecting us, financially, from an event that is guaranteed to occur. Since we know the event will occur, we need to look at it differently.
With life insurance our question is not “what if this happens,” it is a question of when; we know what, we don’t know when.
We know we will pass, we know there will be some form of funeral and final expenses. We get to make a decision on the conditions and situation we leave our loved ones. If we approach it rationally we will probably leave our life insurances to help our survivors.
We may also keep permanent policies for their living benefits, or keep policies to fund charitable legacies. It is very different from any other insurance and warrants a different analysis.
Reducing insurance coverage can be done only with increasing risk. This is not for everyone. Many people can take on a little more risk and save a little in premiums and stay within their comfort zones.
There are different opportunities for different insurances. The goal is not to eliminate all possible expenses; the goal is to make the best financial decisions. Sometimes you can make good decisions and save some money.
Other times good decisions can seem to cost you money, like advancing your education, for example.
We should always be weighing costs and benefits. In the end, it’s what we get to keep that shows us whether our decision was a wise one. You may be able to keep some of your premium dollars, but only if you do so wisely.