Buying insurance is paying somebody to take on some risk that would otherwise be yours. Consider homeowners' insurance. You pay the insurer the average expected cost of damage to your home, as estimated by their actuaries, plus some overhead and profit. In return, the insurer will cover the actual cost of any damage that is incurred. In the average case you come out somewhat behind due to the overhead and profit ("insurance tax"), but in return there's now a cap on the most out-of-pocket expense you could suffer in the worst case.
This is often a pretty good trade-off—there's a pretty good chance your house won't burn down, and you'll end up a little poorer than you would've otherwise, but at least if it does, you aren't left without a house.
Now a common aspect of insurance of nearly all sorts is a deductible: You agree to pay the first $x of any damage, and the insurer only covers amounts past that. This is to keep the whole process from being woefully inefficient:
Ideally, your deductible should be higher than routine expenses, or else you're paying routine expenses indirectly via the insurer. This increases the insurer's overhead, since instead of insuring you from catastrophes they're also acting as your routine payment agent, and therefore they charge you even more of the insurance tax, which you shouldn't be paying anyway on routine expenses.
In fact, it's usually a good idea to have a fairly high deductible on most
types of insurance; the higher the deductible, the fewer expenses that you
perfectly well could've paid for yourself are subject to the insurance tax, and
the less of a hassle the insurance company sees you as and charges you for, since $200 claims come
up much more frequently than, say, $2000 claims. Low deductibles are basically buying insurance you don't need—if you can pay for $1000 of hailstorm damage yourself, don't pay an insurance company more than that to cover it for you. Otherwise, insurance just serves as a roundabout way of getting your own money back after some of it's kept by the insurer.
An exception is if you know that for some reason you're more likely to use the
insurance than the price it's selling for reflects.
More likely, if you're the sort of person who is competent at anything at all, your risk in
many cases is lower than priced: There are a lot of reckless drivers,
hypochondriacs who visit the doctor twice a week, and so on. This is exacerbated by the fact that insurance acts as a moral hazard—if insurance is picking up the bill, people waste money on things they otherwise may not have paid for, so if you're the sort of person who doesn't do that, you don't want to be subsidizing them. (Incidentally, the fact that having a low deductible increases moral hazard by removing the client's financial stake in the affair is another reason insurance companies charge people with low deductibles disproportionately more.)
Car insurance is a canonical example: If you're under 25, and don't drive like a complete idiot, you're probably priced as a higher risk than is really justified,
because most people under 25 are apparently either reckless or incompetent or
both, and the insurance companies don't have good ways of distinguishing. This
argues for raising your deductible as high as the law and your savings allow.
For example, a few years ago I raised my collision deductible from $500 to
$1000. This saves me $200/year, which means that it was priced such that I was
expected to have an $1000+ accident every 2.5 years. Obviously that's a
ridiculous over-estimate, and over the five years since I've done that, I've
saved $1000 in premiums—enough so that even if I now totalled two cars in a row,
paying the $500 extra deductible each time, I would still break even.
Related to but even worse than buying insurance with an unnecessarily low
deductible is buying insurance on something too cheap to be worth insuring at
all. Almost all "extended warranty" plans fall into this category.
Manufacturers are obviously going to want to at least break even on selling
warranties, so they charge you at least the expected failure rate times the
product price; in most cases, they charge much, much more, which is why they're
so aggressive in trying to sell them to you. (I should note that some
service/repair plans don't fall into this category. In those cases, you're
paying for the convenience of not having to go through the hassle of
fixing/replacing something yourself if it breaks, not just insuring the
product. Whether those are worth it depends on how highly you value saving
As a final caveat, note that this all applies only if you're actually buying
insurance. If, say, your employer is paying for your health insurance (or a
significant percentage of it), that's just your employer paying (some of) your
health costs, using the insurance company as the middleman by which to do so,
which is a completely different situation. In fact that may be the source of
much of the confusion: People seem to think an insurance plan covering routine
expenses with a very low deductible is a good thing, which it is in the case
where you're not the one paying the insurance premiums (but only in that case).
If you're buying your own health insurance, the above advice applies, but to an
even greater extent than with most types of insurance, because people with
high-deductible health insurance (over $1050 for individuals or $2100 for
families) qualify for health savings
accounts, tax-exempt savings accounts that can be used to pay health
expenses up to the deductible (or $2700, whichever is lower), which is
basically like the federal government paying 15-35% of your deductible,
depending on your tax bracket.
So, in summary:
- Insurance is a means by which you pay someone to take on risk for you.
- In return for taking on the risk, insurance companies charge you the overhead of
administering the insurance program plus a profit.
- Therefore, you should only use buy insurance when you actually need someone to take on some risk for you, and it's worth paying the overhead. Don't
pay someone to take on minimal amounts of risk, and don't use insurance companies as
an indirect and expensive way of paying routine expenses.
- Default deductibles on most types of insurance are much lower than is cost-effective. Save the money on premiums and stick it in a bank account to "self-insure" for relatively minor things.
- In particular, look for places where the implicit estimate of risk is considerably higher than seems reasonable, and increase your deductibles until the premium/deductible
tradeoff looks better.
(This is part of an informal series of personal finance articles I've written here; previous articles cover credit cards and online savings accounts. An earlier version of this op-ed also appeared on a personal finance site I maintain.)