TLDR

This piece helps you understand how to buy insurance and what you should think about when you buy it.

The strategy for buying is:

1. Estimate the worst-case cost: Think about the worst-case scenario for the risk you're looking to cover and estimate what it would cost you (e.g. for car insurance, the worst-case scenario is totalling your car, and the cost would be the purchase price of a replacement car)
2. Check the adequacy of your savings: Check if you can cover the worst-case cost using money in your savings account (e.g. if a replacement car is $15k, check if you have $15k in your bank account)
3. Based on the adequacy choose to do one of the following:
   • You have enough savings: If your savings can cover the worse-case cost, don't bother buying insurance. Instead, just self-insure. (Instead, take the premium you would have paid, and put it in your savings account)
   • You don't have enough savings: If your savings can't cover the worse-case cost, buy the insurance to cover your worst-case cost.
4. (Optional) Setting an excess: If you can choose your excess, set your excess as high as possible but no higher than the amount of money you have in your savings account. (E.g. if you can choose an excess of $800, $900 or $1000, and you have $950 of savings, then your excess should be $900)
5. Exceptions - Check for rorts: Buy insurance if it is possible for you to rort it. Avoid insurance if the government turns it into a way to rort you.

Note that a longer-term consequence of thinking in this way, is that as you build up your savings you can cancel various kinds of insurance.

Now we get into the article that covers how to think about insurance, mainly by comparing buying insurance to self-insurance.

Start by thinking "Why not self-insurance?"

Before buying insurance, adjust your frame by asking yourself "Why not self-insurance?"

Self-insurance is when you don't buy insurance and use your savings to cover any issues that arise. You can think of it as using your savings account as your insurer.

For example, if you were going to buy travel insurance, primarily to cover hospital bills in a foreign country ask yourself, what if:
1. I didn't buy the insurance
2. I saved the premium in my savings account
3. If the worst-case scenario happens, I'll just pay for it out of my savings account

If you actually have enough savings for step 3, you should do self-insurance.

If you don't have enough savings for step 3, then buy the insurance.

Fair Insurance (against an insurance company) is almost always negative expected value

The reason for self-insuring is that insurance is like a casino game (blackjack, roulette etc.) - the odds favour the house. Insurers hire teams of actuaries to assess the relevant risk, and charge more than they expect to pay out.^[1]

In fact, the pool of insurance premiums that an insurer collects can be broken down into several categories:
1. Payout for claims
2. Cost of administration
3. Profit
4. Taxes

In fact, sometimes regulators will helpfully prepare charts like this one, on NSW Compulsory-third-party car insurance:

Helpfully, actuaries will also calculate a "loss ratio" or ratio of "Payout for claims" to "Premiums collected". In the chart above, this is the ratio of the "Insurer risk premium" to "insurance premium". ^[2]

Before I give you the answer: Want to guess what the loss ratio of NSW CTP insurance written from 2000 to 2012 is?^[3]

It's about 53% to 72%, with the majority of years below 65%. So, 65c of every $1 of premiums collected (excluding taxes) got paid out as a claim. Once you count taxes, it looks even worse!^[4]

Buy insurance for catastrophic risks

You should buy insurance for catastrophic risks. An alternative way of saying the same thing is, buy insurance against things that will bankrupt you.

Given that insurance seems like such a poor bet, buy it only when you can't manage the fallout if the relevant incident occurs.

For example, you are worried that you might have to pay for cancer treatment that could cost $100,000. You do not have $100,000 in your savings account. Go ahead and buy health insurance that covers cancer treatment. On the other hand, if you reckon that you'll deal with a cancer diagnosis by going through the public system, you can just skip the insurance.

On that metric, you should probably have insurance for most types of catastrophic risk - health insurance, life insurance and if all your money is tied up in a house - home insurance.

How to choose your excess

Sometimes insurance will allow you to choose your excess. In line with the rule of insuring only catastrophic risks, you should your excess as high as possible, but no higher than the amount of money you have in your savings account. This can often dramatically reduce your insurance premiums.

An excess of $X is a way for you to say to the insurance company "I will cover the first $X of expenses associated with any claim". In addition, it signals to the insurer that you are a good risk with regards to moral hazard (see below), and reduces the expected administration cost of your policy, since minor claims won't actually get filed with the insurer.

For example, I recently had to buy comprehensive car insurance. The options included:
1. $1,000 excess (default) for a premium of $2,235/year; vs
2. $1,900 excess for a premium of $1,767/year
Increasing my excess reduced my premium by $468/year less, equivalent to a 21% discount.

As a result, you want to buy insurance to cover situations where you need more money than what's in your savings account. If something happens and it costs less than the money in your savings account to fix, then just use your own money first.

On the flipside, don’t set your excess above your savings, otherwise you won't be able to pay the excess in the event you use the insurance.

Exceptions (aka rorts)

There are some exceptions to the rules above, specifically:

1. Information advantage
2. Fraud
3. Government rorts

Information advantage -

People often think they have an informational advantage over the insurer, but this is less common than you think.

If you know something that the insurer doesn't, and it tells you that you're more likely to claim on the insurance, maybe you can buy the insurance.

I will emphasise that this is not the same thing as being more likely to use the insurance than "average". You need to actually know something that the insurer doesn't know.

Knowing you're a bad driver doesn't make car insurance a good deal. You actually have to be sure that the insurance company can't tell you're a bad driver (e.g. all your recent accidents were overseas). Otherwise, the insurance company will just charge you accordingly.

Fraud

If you can do insurance fraud, insurance may be a good deal.

For example, someone I know patronised a corrupt optometrist who would bill their family health insurance policy for new glasses every year and then credit an off-the-books account that they could use on whatever they wanted at the store. Deals like this may be easier to come by depending on your social circles.

Exercise judgment accordingly.

Government rort

A lot of insurance markets are manipulated by the government as a way of cross-subsidising particular cohorts to further social policy aims.

You can more easily identify government rorts if you remember that they are often advertised as equity initiatives or social policy. If you notice a cross-subsidy applies, then:

• If you're likely to get a cross subsidy - buy the insurance.
• If you're likely paying to subsidise others - don't buy or minimise the insurance.

A brief example may be illustrative. If we look at health insurance in Australia
The government helpfully points out how wonderful their social policy is:

Submitters to this inquiry were almost unanimous in their agreement that community rating and risk equalisation are important to the effective operation of the existing private health insurance regime.

The policy is explicitly described as a cross-subsidy

In its Efficiency in Health report, the Productivity Commission noted that 'community rating and other price regulations effectively act to cross-subsidise private health insurance premiums'. The Department clarified that:

Community rating prohibits insurers from discriminating on the basis of past or likely future health or risk factors such as age, pre-existing condition, gender, race or lifestyle in the premiums that they charge. Although community rating means that people who are older or sicker do not have to pay higher premiums commensurate with their risk, it also means that younger and healthier people pay more than they otherwise would.
Source: Chapter 3, Value and affordability of private health insurance and out-of-pocket medical costs

Health insurance in Australia is manipulated to ensure young people subsidise old people. As a result:

• If you're young, minimise your health insurance.
• If you're old, buy in to health insurance.

When you can't choose

To prevent individuals who are cross-subsidising others from avoiding insurance altogether, governments also use compulsion to force people to buy insurance.

In those circumstances, you should act strategically and consult your accountant/lawyer.

Examples of various forms of compulsion include:

1. Taxes: Health insurance in Australia is also manipulated through the tax code to tax high-income young people if they don't buy health insurance. If you're young, consult your accountant about this.
2. Making insurance compulsory: NSW imposes a cross-subsidy on its compulsory third party insurance product to ensure universal affordability. This means safe drivers subsidise high risk, dangerous drivers (think of a 19 year old male driver in a 19 year old car).^[5]
3. Manipulating defaults: Many superannuation funds default young people into an insurance product that is inappropriate for their circumstances. This is justified as it makes the insurance more affordable for people others in the superannuation fund.

Appendix on NSW CTP - Competition and regulation

A brief aside on the NSW CTP scheme on the differing impact of price regulation and competition on profit margins.

Price regulation in action

NSW CTP is a regulated insurance product, with a regulator that approves premium prices to prevent insurers from earning "excess profits", and this is a nice example of looking at some of the difficulties in price regulation.

If you look at the chart below, you might notice that the lines generally slope down. That is to say, for each vintage ("accident year") of insurance policies written, the actual loss ratio assessed after 5 years is much lower than the estimated loss ratio calculated when the policy was written. In fact, as experience comes in, the losses turn out to be lower than expected.

And what do you know, with payouts lower than expected, profits are correspondingly higher than expected (see chart on page 20)!

It's genuinely funny how every year, the insurers file premiums with the regulator predicting high loss ratios and low profits, and then 5 years later, everyone's surprised when loss ratios are lower and profits are higher.

Competition in action

Before you despair, there is also a competition story here.

You will also note from the chart of estimated insurer profits based on each vintage ("accident year") of insurance written, that each vintage of insurance premiums tends to have lower profits than the last. This is seen most dramatically the period 2006 to 2010.

That steady erosion of profits looks a lot like price competition over time. And if you're wondering why competition plays out so slowly, note that the insurers adjust their premiums once a year as a result of the regulated nature of the pricing.

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1. In fact, it's generally illegal for an insurer to charge you less than it expects to pay out. APRA exists to ensure that insurers charge more (i.e. enough to cover their losses) and its current approach to insurance regulation was formed in the aftermath of HIH, which was an insurer that charged less than it needed to, became Australia's second largest insurer and then went spectacularly bankrupt. ↩︎

2. Note that an insurer that makes $0 profit still cannot have a 100% loss ratio, as it has to incur the cost of administering insurance (collecting premium, sending letters, assessing claims etc.) ↩︎

3. You might wonder why I didn't include the accident years past-2012. The reason is that these loss ratios are calculated based on the actual performance of claims, which in the case of CTP take about 5 years to come in. The delay is in part because payouts are dominated by a relatively small number of catastrophic claims (think lifetime of care), with several years required to get a good estimate of how much needs to be paid. You can see this dynamic on the chart on page 21. ↩︎

4. In comparison, that the house edge on Blackjack is about 0.5% to 2% if you play "basic strategy", which implies a loss ratio of 98%. So when I compared insurance to Blackjack, that was a bit unfair to casinos. ↩︎

5. This is one of the few circumstances I know of where a government explicitly regulates against safety. It's pretty extraordinary that the government actuaries can precisely measure the number of additional fatalities and serious accidents that result from a particular behaviour and then actively subsidise that behaviour. ↩︎