March 26, 2009

When to self insure

For many things buying insurance from an insurance company is your wisest financial move. Home insurance, life insurance, health insurance and auto liability insurance are best to buy insurance coverage for. Very few of us can afford the large potential out of pocket expenses for the costs from major events like a home fire or a hospital stay. If you don't have insurance for these things you're likely running the risk of financial disaster. Proper insurance can guard you against ruin in the event of a disaster. But you don't have to buy insurance from a third party insurance company for everything. For some things it is OK to self insure.

Self insurance is where you maintain sufficient financial ability to pay for a problem out of your own pocket. You may not realize it but you self insure many things. Virtually all low cost items are self insured. You don't have insurance against a broken pencil or a ripped shirt. That choice is simple since those items are cheap and easy to afford replacing out of pocket. As the potential bill increases it makes more sense to get insurance to cover the costs.

The things to look at if you are considering self insuring involve both the consequences and the costs. You could look at this as making two key decisions: Do you care? and Can you afford it?

First consider the consequences.

Can you do without the item or service?
What is the worst case if a problem arises?

If the consequences of a potential disaster are not too significant then you can likely do without insurance altogether. Say for example you have a second car and it is owned free of a loan. If the car is old enough you might do without comprehensive insurance. If you then get in an accident that is your fault you may have to do without a second car. The consequence of this disaster is not very significant either financially or in terms of impact to your life. On the other hand if you are considering going without long term disability insurance then the worst case scenario would potentially leave you and your family financially destitute. So it comes down to basically answering the question : Do you care? For example, do you care if your second car sits idle? Maybe not. Do you care if you go bankrupt due to medical bills from emergency surgery? Almost certainly you would.

Second consider the costs.

What is the maximum liability involved?
How likely is it that the cost will occur?
What is the cost of buying insurance from a third party?
What are is your emergency fund balance and total assets?

If the maximum liability from a problem is very high then it is not usually a good candidate for self insurance. If there is no possible way you could afford the costs out of pocket then its something you should really consider buying insurance for. But you should also look at how likely the event might be. Buying flood insurance when you are very far from water may not be necessary. But if you are on a river bank then flood insurance is probably a good purchase. Once you've decided if the insurance is something worth getting and something you can possibly afford out of pocket then you should consider the cost of self insuring versus the cost of buying insurance. Just because you can afford to self insure doesn't mean its necessarily the best option.

Evaluating the cost of insurance:

One way to look at the cost of buying insurance is to compare how much you would be paying in insurance bills versus the average cost of going without the insurance. First figure the likely costs of the disasters for a one year period. TO do this find the probability of the cost being incurred and multiply it by the average cost. For example if its 10% likely that you may have an auto accident in any given year, and if the average cost of an accident is $10,000 then we can estimate that the average annual cost is going to be $1000. If your auto insurance policy costs significantly more than $1000 then it may not be a particularly good buy.

Adding it all up:

First determine if the event is significant enough for you to care about. Some losses are not large enough or impactful enough to bother worrying about insurance against.

Second figure if its feasible for you to self insure or not. If you have emergency fund or assets capable of handling the cost then self insurance might be an option for you.

Third compare the costs of buying insurance to handling the cost out of pocket.

Lets look at a couple examples.

Pet insurance: I've talked about pet insurance in the past and I've generally concluded the insurance is not a good buy. If you look at specific numbers: I could get a pet insurance policy for my cat for around $120 a year. On the other hand the average vet expenses in America are about $80 a year. The maximum amount I'd end up paying for a vet bill is something I could handle out of pocket. In this case self insurance is a pretty good option.

Long Term Disability: If I were to become disabled and not able to perform my job then we would be out our primary income generator. Our total assets are not quite enough to cover this cost. This example is something that is very important and also something I can't quite handle self insuring. The risks are not extremely high, but the negative consequences are quite high. I could take the risk and try to self insure against the likelihood but it would be risky to do so.

Self insurance can be a feasible option for certain things. The exact answer will depend on your financial circumstances and the potential impact of an event or loss.

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