Why for many self-insuring can be a smart move

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In today’s world, increasing financial resilience is challenging yet when done correctly, self -insuring can provide significant cost savings, flexibility and control.

Key takeaways:

Insurance is better mainly for losses that we cannot afford and as a result some policies, or coverage options may not be great financial investments.
Self-insuring can be done in the form of higher deductibles, co-insurance, lower limits, or not purchasing an insurance policy all together.
People self-insure risks every day – cell phones, travel, going online, skiing, etc. Sometimes the “pros” make self-insurance seem scary or out of reach for average consumers (often in an effort to sell them something), that’s not the case. It just comes down to understanding the risk/reward of a particular risk.
Self insurance requires a rainy day fund, which means putting aside money should an event occur, By saving money on insurance premiums, you can invest that money and benefit from the compound interest of your savings.
Self insurance requires financial discipline and a holistic approach. Increased awareness to risk must also be considered.

Insurance premiums can quickly add up: healthcare, car, house, disability and life, just to name a few. And if you never claim, it can easily feel like you are pouring money down the drain. There is another option – self-insuring. But you want to be careful.

Insurance vs. self insurance

Here is a general rule of thumb: Insurance is usually built for losses that we cannot afford or it will be too expensive for us to cover. When we can afford the loss, insurance may not have the best return on the investment and as a result, it might financially not always make sense.

When you self-insure, you set aside extra money to pay out of your pocket for any losses or damages, if and when they occur instead of paying a premium to an insurance company to cover your losses when they occur.

The basic idea behind this, is that you will save money by avoiding making regular premium payments so that you have money to pay for damages if a loss occurs — which may or may not ever happen. However, you will need to be financially disciplined and to not actually invest the additional savings rather than spending it. Also, the investments should not be made into highly illiquid opportunities, so that in the event of loss, funds can easily be made available.

Self-insurance is the process of establishing a fund that you will use to cover the costs of a loss. It does not eliminate or control risks; it provides a means of covering losses that you will have only if the damaging event occurs.

What is self insurance in the context of risk management

Risk is a fact of life. We can make active decisions on how we want to handle risk, and in doing so, we have several options at our disposal.

Avoidance – this is when you eliminate the source of the risk. For example, if you don’t own a car, you cannot have your car stolen.
Loss mitigation and prevention – where the point is not to eliminate the risk, but to reduce/control it by, for example, wearing a seatbelt while driving.
Risk transfer – The contractual risk transfer to others, like an insurance contract.
Risk retention -where you keep the risk and pay part or all of the losses when they occur.

How to self-insure
You can self-insure by dropping certain insurance altogether or by being very intentional when choosing an insurance policy.

In the first case, you are left without any coverage for a particular risk, which means that you will be responsible for the full amount of losses. This approach may not work well with certain policies. For example, some policies may be required by the law. Also, self-insuring for events that may result in extremely high expenses, such as critical illness (heart attack, stroke, organ transplants, etc) may not really make financial sense and the cost of affording them might outweigh the cost of purchasing insurance.

The second option is to tweak your insurance policy to optimize for protection and price. You can do this by choosing:

Insurance policies with higher deductibles as they have lower premiums, so cost less. This means that up to an amount equal to the value of the deductible, you will be responsible for covering your losses. When your losses exceed the value of the deductible, the insurance company steps in and covers your losses based on the agreed amount. Additionally, it means that you choose to self-protect up to the value of the deductible and save your insurance for higher-cost events, which would be much harder to cover out your own pocket. Limit the coverage and choose more restrictive options. Be intentional about the protection that you need and pinch out any excess coverage that may look good on paper, but you don’t really need. For example, if you have an old car with a high depreciation in value, dropping your collision coverage does make financial sense.
Choose policies with a long elimination period. The elimination period, often found in long-term care and disability insurance policies, is the time you need to wait before your benefits kick in. Longer elimination period policies have lower premiums. Short-term disability insurance will have a shorter elimination period, usually up to 14 days. Long-term disability insurance policies typically have an elimination period ranging from 30 to 365 days, but some insurers offer even 720 days elimination period – so there are plenty of options to choose from.

Keep in mind that self-insuring doesn’t mean that you go uninsured. Instead, it means that you assume responsibility for financial losses that you may incur, rather than shifting these risks to an insurance company.

It also doesn’t mean that you just randomly drop whatever insurance policy, rather that you are being very intentional about selecting a coverage you really need.

Assuming financial responsibility for losses that may incur is truly an option if one can afford it and understands the insurance technicalities that would be waived.

Why self insuring can be smart for some and how the economics of it all works

Let’s start with how the economics for insurance work. Putting aside the investment, for most common insurance products, there are 4 key metrics: Gross Written Premiums (GWP), Loss Ratio, Expense Ratio, Underwriting Profit.

Gross Written Premiums (GWP) is the sum of all the premiums that are paid to the insurance company in that region for that insurance product in one year. A very large portion of this money is then paid back (or expected to be paid back) to the policy holders for claims.
Loss Ratios is the ratio of all the premiums that is paid back. For example, for auto insurance typically the loss ratio is around 60%. Meaning that if a company collects a total of $100M in premiums from all its policyholders in a region, a 60% loss ratio means that $60M is expected to be paid out in claims.
Expense Ratio is the ratio of all the expenses of an insurance company in order to operate, in comparison to the GWP. This includes distribution costs, loss adjustments, operation expenses, etc. For our auto insurance example ,most companies have an expense ratio of 30-40%.
Underwriting profit is the profit that is left after the claims and expenses are paid out. So by adding the expense ratio to the loss ratio, and deducting that from the GWP, what remains is the underwriting profit. So in our auto example if a company runs on a 60% loss ratio, 35% expense ratio and $100M GWP, their underwriting profit would be 5% of the GWP, or $5M.

These metrics are important because it’s how an insurance company prices a premium based on an individual’s risk profile.

For example, what is the statistical likelihood of a 35 year old, male, in the zipcode of 94085, and no driving accident to have a claim of $50,000?. If the odds of that is a 1% chance to happen this year, then the expected loss for that profile is $500.

Using that number, insurance companies add their overhead expense ratio and charge you a premium. For our example, if the company has an expense ratio of 35%, your premium would be something around 135% of $500, or basically $675. Basically, the $500 is the money they expect to pay to people like you on average, and the $175 is their profit.

So why all this technical jargon? Because this is the key to why self-insurance can be great for all risks that you can afford.

Let’s walk through an example: Let’s say you have $30,000 in your rainy day fund, and you have a $5000 car. Imagine you are trying to decide to purchase comprehensive insurance for your car or just collision damage. If the expected loss for someone like you suffering from a total loss ($5000) is $300 a year, the insurance company with a 35% expense ratio will probably charge you around $405. That $105 is exactly the amount of money that you are expected to save that year by not spending money on insurance on average. Money can then be saved, compound interest would be significant and assets grown.

Example: How self-insurance can lower the cost of insurance
Most insurance companies who offer auto or home insurance, have to file their rates and their pricing with each state in the United States. The idea is to make the process of how pricing works transparent. These are called rate filings. Higher deductibles are more cost-efficient and actually coincide much better with self-insurance.

Here we have looked at a few major US carriers in 2020.

The USAA rate filing shows that for Collision coverage, a $500 deductible is the standard offered deductible. By decreasing the deductible to $50, the price for that specific coverage (just the part of the premium that is paid for collision and not the entire policy) can be increased up to 80%, depending on the car model. Increasing the deductible to $1000, can result in savings of around 20%. Meaning that the difference between the lowest deductible option can cost twice as much as the highest deductible option.
For comprehensive coverage, there is an option to waive the entire deductible (deductible of $0). This can increase the premium cost for comprehensive coverage by a factor of 250%. The cheapest option would be a deductible of $1000, which results in savings of up to 30% from the $500 deductible base rate. Meaning waived deductible can be more than three times as expensive as the highest deductible.
For Chubb Insurance, the rate filing shows that from the setting a deductible of $5,000 can be 30% cheaper than a deductible of $250.
For Progressive Insurance, a deductible of $100 can be more than twice as much as the deductible of $2,500 for collision insurance, and over three times as much for comprehensive insurance.

Please note on average the collision and comprehensive coverage are 30-40% of the total policy cost.

Example: Long Term Disability Insurance
Looking at options for a 35 year old male, we compared quotes for an elimination (waiting) period of 60 days versus 365 days. On average, the higher elimination period is 40% cheaper than the lowest option. Though, to typically cover the elimination period you can purchase a Short Term Disability insurance which usually costs as much as the Long Term Disability Insurance, Meaning it can double the premium costs and in many cases it is not the best return on the investment.

Example: Health Insurance
Looking at quotes from Blue Shield of California for a PPO plan, we compared a high deductible Bronze (Co-insurance of on average 40%) plan, with a Gold (average 20% Co-insurance), with a Platinum (average 10% Co-insurance). The respective plans cost $1659, $2600, $3400 a month. Meaning that the Platinum plan costs twice as much as the high deductible plan.

For a single 35 year old male, the Platinum plan costs a little over $1000, whereas the High Deductible plan costs around $500.

Self-insurance is a useful approach in the case of smaller and predictable losses. In other words, the lower the potential loss or, the more predictable it is, the more it makes sense to self-insure.

Considerations

Self-insurance will work better in some situations than others, while in some cases, it won’t work at all.

Some insurance coverages are legally required, such as auto insurance required by state regulations (though liability loss limits will vary between states) and health insurance. Homeowners insurance will be required for those who bought their homes through a mortgage.
Self-insurance depends on the financial buffer that you have, or excess money stashed away to cover a loss. Self-insurance does not benefit from diversification across multiple insureds, and therefore it can become quite capital intensive.
A key factor when considering self-insurance is the potential size of a loss assessed against your own financial resources and the cost of liquidation and taxes for different asset classes in the event of a loss.
Keeping a portion of your assets more liquid in order to self-insure can result in less financial gain compared to investing them in less liquid asset classes.
Self insurance has a higher degree of discipline which would not necessarily work for all where insurance can help. Having additional savings can result in spending more rather than allocating it to a rainy day fund.
Discounted insurance plans at scale and the power of group purchasing can lower the associated costs of recovery and claims. Self -insurance cannot provide this. Many times when it comes to some insurance products like dental DHMO or vision plans, insurance companies negotiate discounted rates with the providers which can result in savings.
Minimized stress and risk: Many people prefer not to worry about anticipating risk even if financially costs more. In addition, for many, affording a loss might mean selling a property or liquidating other assets in which that cost of liquidation might just be too high.

However, it is important to keep in mind that you can’t look at the potential loss in isolation – you need to look at it from your own financial perspective. This is why you need to assess the size of potential loss against the money you have saved away for covering unexpected expenses, which we usually call an emergency fund.

Finally, the decision should always be based on an individual’s risk profile, objectives, and personal financial situation. Life is full of risks. To your family. Your assets. Your future. The problem is traditional solutions propose traditional answers. Let’s make sure you’re protected.

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Life is full of risks. To your family. Your assets. Your future. The problem is traditional solutions that propose traditional answers, one policy at a time.

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