Practical analysis for investment professionals
03 November 2014

Only Buy Insurance When You Can’t Afford the Loss

Posted In: Drivers of Value

In very rough terms, the world of insurance is divided into life and non-life. Non-life insurance is for such things as your car, house, travel, company, and other non-life things. We all know how it works. You pay £500 to insure your car against a number of things, including, for example, theft. Let’s say your car has a value of £10,000. In simple terms, the probability of making a claim against the full value of the car in any one year has to be 5%. Without necessarily thinking about it in those terms, most buyers of insurance probably think that sounds about right, so they think the insurance is worth it.

Avoiding the Combined Ratio

The reason I would not buy the £500 insurance on my £10,000 car (other than the third-party insurance required by law) is because of my knowledge of the insurance company’s combined ratio. The combined ratio is the sum of the claims ratio and the expense ratio. The claims ratio is exactly that — what the company pays out in claims to people whose cars are stolen or damaged. And the expense ratio is all the other costs of the insurance company: marketing, administration, overhead, and so on. Insurance companies can have combined ratios of more than 100%; if claims don’t come due for a while, the insurers earn interest on the premiums they collected until the claims come due. But because car insurance is typically a one-year policy, the combined ratio for this policy should be less than 100% to be profitable.

For car insurance, the risks are somewhat predictable and the insurance company is likely to have a good idea of the number of claims and expenses it will face (insurers can reinsure risks they don’t wish to hold fully themselves). Using very rough numbers, the insurance company might have a combined ratio of 95% for these policies, made up of a 70% claims ratio and a 25% expense ratio (my friends in insurance will bemoan this simplification). So, if you are an average risk customer, every time you pay £100 in premiums on your car insurance, you get £70 back in claims, it costs £25 for the insurance company to make it all happen, and the company takes a £5 profit. In other words, on average, you are paying £30 for the peace of mind of having the insurance. You obviously don’t get £70 back. In fact, most of the time you get nothing back because you didn’t make a claim on the insurance company.

The Amount of Risk One Can Afford to Bear

Accordingly, the reason I don’t buy insurance is that I don’t want to pay the 30% in cases where I can afford the loss (25% expenses plus 5% profit to the insurance company). Obviously it would really stink to have my car stolen or damaged to the tune of the full £10,000, but I see this as a risk I can afford to bear and don’t need to pay to protect against. Importantly, I also don’t think that I save the full £500 in annual car insurance. I think that I save the 30% difference between what I paid and the average claims. In my view, the insurance company knows as much about my risk as a buyer of insurance as I do, and if they set the average payout for me at 70% of a £500 policy, then that is probably about right. So, let me use this case of car insurance to extrapolate how I think about insurance in general: On average, over all the insurance policies that I don’t buy, I would expect to have a loss of £350 (70% of £500) on my car in any one year and have saved £150 by not buying insurance (30% of £500).

Not buying insurance against things we can afford to replace or have happen does not mean that those things will not occur. It just means that instead of having the small bleed of constantly paying premiums for a lot of small things, we will once in a while be paying out larger replacement amounts for things we did not insure against. Personally, I also think the whole hassle of keeping track of insurance policies is a pain I would rather avoid because I seem to constantly hear stories about insurance companies that either fight claims or make claiming on a policy a huge headache.

Without being scientific about it and including all insurance forms that I don’t buy (including life insurance), I think I save about £500 a year in expense ratio and insurance company profit. Assuming that I took this money every year for the next 30 years and invested it in the broader equity markets and was able to return 5% on that money, my savings from not buying insurance over the period would amount to around £35,000 in present money. This amount is money that I have instead of money that is in the insurance company’s pockets in 30 years. Importantly, this savings does not assume that I do not have accidents or have my car stolen. In fact, it assumes that I am at risk of those things with the exact same probability that the insurance companies assume.

The Amount of Risk One Cannot Afford to Bear

Investment advice typically has an “always seek expert advice” or “don’t try this at home” disclaimer, but here it really applies. You should not save on insurance premium payments in instances where you can’t afford the loss, and everyone is different in terms of what loss is affordable. Most people cannot afford to lose their house in a fire, so they should insure against this possibility (you probably couldn’t get a mortgage if you didn’t). Most people in countries without national health services probably can’t afford health-related problems and should get health insurance. Many can’t afford to have bad things happen to their car, so they should insure against that. But most people can afford to lose their mobile phone, cancel a flight or vacation, or suffer an increase in the price of their electricity bill, and they should not insure against those things. And for those things you need to buy insurance for, you should always get a high deductible, which, in turn, will lower the cost of the insurance policy. Over time, having no insurance or a high deductible when you do will save you quite a bit of money, and that should help you sleep better at night.

Similarly, there are many instances when life insurance makes sense. As with the case of annuities, many life products have an investment component to them as well. If you are in a situation in which your death or disability will cause unbearable financial stress on your descendants, then the premium you pay on these policies makes sense. As with the example of car insurance, you should do so when you or your descendants can’t afford the loss. Whether they can or not afford the loss is obviously a highly individual thing, but keep in mind that as with all insurance products, there is a tangible financial cost to the intangible peace of mind many people cherish who have insurance. Make sure it is worth it.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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Lars Kroijer

Mr. Kroijer (born 1972) is the author of "Money Mavericks - Confessions of a Hedge Fund Manager" (Financial Times Press – 2010 & 2012 - 2nd edition) and “Investing Demystified – How to Invest without Speculation and Sleepless Nights” (Financial Times Press - 2013). Mr. Kroijer currently serves on the Board of Directors of OVS Capital, Linden Grove Capital, Northlight Capital, Steadview Capital, and Maj sinAI (London, Mumbai/Hong Kong, and Copenhagen based hedge funds), and ShipServ Inc. (the leading online platform for shipping supplies with annual sales of appx \$4 billion). He has frequently appeared as a finance expert on a broad range of media, including BBC, CNN, CNBC, Bloomberg, NY Times, Forbes, etc. Previously Mr. Kroijer was the CIO of Holte Capital Ltd, a London-based market neutral special situations hedge fund which he founded in 2002 before returning external capital in the spring of 2008. Prior to establishing Holte Capital, Mr. Kroijer served in the London office of HBK Investments focusing on special situations investing and event-driven arbitrage. In addition, he previously worked at SC Fundamental, a value-focused hedge fund based in New York, and the investment banking division of Lazard Frères in New York. While in graduate school Mr. Kroijer held internships with the private equity firm Permira Advisors (then Schroder Ventures) and management consulting firm McKinsey & Co. Mr. Kroijer graduated Magna cum Laude from Harvard University with a degree in economics and received a MBA from Harvard Business School. A Danish national, Mr. Kroijer lives in London and is married with twin daughters.

3 thoughts on “Only Buy Insurance When You Can’t Afford the Loss”

1. I agree with the thrust of the article, which is that the decision to buy insurance should be driven by a sensible evaluation of the probability and magnitude of future losses.

That being said, one topic that could benefit from further discussion is the interplay between the deductible (or retention) and the cost of the policy.
Insurance is more economically beneficial where the focus is on “catastrophic” losses – like a home destroyed by fire. Milton Friedman touched on this in “Capitalism and Freedom” when discussing health insurance. One does not insure one’s car for needing to have the tank filled each week, but rather for the car being totaled in a collision. Similarly, Friedman’s view was that health insurance would be more beneficial if it provided “catastrophic” event coverage (today, that might be anything costing more than \$5,000 in a year, for example) – but that coverage for routine checkups and ER visits did not make sense because premiums would have to be inflated accordingly. (A full discussion would also consider the incentives of having a portion of “retained loss” – healthier living habits, perhaps!)

Coverage for “mundane” losses of small magnitude but high frequency add to the administrative cost (the expense part of the combined ratio) and to the premiums. In a way, insuring such items is a “premium multiplier” because one pays premium not only for the actual losses, but also for the insurance co’s expense in administering the claim, thus “multiplying” the cost of the ER visit.

For all these reasons, the decision is not just whether to buy insurance, but to set the deductible at a level that avoids “trading dollars” with the insurance company for routine minor losses.

2. Phil says:

I am in full agreement, but the state I live in requires by law that liability coverage of minimum \$30K be owned by any motor vehicle operator. I have been in a few accidents and always pay out of pocket for repairs, I am wealthy and essentially self insure these issues, but the DMV wants me to show proof of a 3rd party insurer that is taking on the responsibility. Insurance is quite a racket. It is now popular with hedge funds to start re-insurance companies in low tax jurisdictions to get a permanence of capital and low tax on investment gains. Do you have any opinions on this trend?

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