On Insurance
Here’s the most important rule on insurance:
Insurance works only as a financial risk transfer.
As a result, the single question you must always ask when buying an insurance product is this:
What financial risk am I transferring from myself to the insurance company that I can’t get rid of in any other way?
If you can answer that question clearly and concisely, then you should go ahead and purchase insurance for that risk.
Here are good examples of personal financial risk transfers for which you probably do need insurance:
Each of those events, though relatively rare, may cause a catastrophe for which few people are financially prepared. Auto, homeowner’s, disability, health, and life insurance can transfer these rare but catastrophic financial losses away from you personally and on to a big corporation. You should pay money to the insurance company to transfer those risks. Even if you never end up needing the insurance, you can be happy to have had the risk financially removed from you and put onto that company.
I know many bad types and uses of insurance, however, so the thrust of this chapter is to warn you against buying too much unnecessary insurance.
The marketing folks of the insurance industry would like to fog up the answer to my single question about risk transfer. The insurance industry would have you believe that risk transfer goes together with things like investments and emotions and safety blankets, in a nice big comfortable package. Remain skeptical.
“Let me sell you this fuzzy blanky comforter,” the insurance salesperson says, attempting to tuck you into a nice annuity product that provides steady income without risk. “You are a child,” the insurance marketing seems to whisper into your ear, “and you deserve a fairy tale full of unicorns and rainbows. Investments and risk transfer snuggle up together in the comfiest way.”
That, right there, is a garbage-filled fairy tale clogging up your financial future. It has funded the construction of the tallest buildings in your city—usually owned by insurance companies. Don’t be a child, and don’t believe it. Don’t pay too much for too much of a safety blanket. Investing most definitely is not the same as transferring risk. If you want to get wealthy, remember that the investment part of insurance is something you should never pay for. Insurance companies try to sell us “fixed annuities,” “variable annuities,” and “guaranteed income” products, which are supposed investment products, but with some safety features to make us feel fuzzy and warm. If you want to get wealthy, you should not buy too much insurance, and you should not mix insurance with investments.
If you follow that rule, you will end up wealthier.
For the remainder of this chapter I’ll present a few more items we should know about insurance, always keeping in mind the single question about risk transfer. These items include:
Definitions of Terms
Premium: The premium is how much you pay for your risk transfer. This might be an annual payment, like in some life insurance or homeowner’s policies, or it might be a monthly payment. The premium makes up the cost of the insurance you’ve bought. When you stop paying the regular premium, the insurance company stops guaranteeing your risk. Your policy lapses.
Premiums for life insurance are supposed to be fixed, and many term and whole life policies have a fixed premium for the life of the policy.
However, some whole life insurance providers—ones that may advertise through television with well-known celebrities—adjust their premium upward after 2 or 5 years, a policy that will on the whole discourage customers from keeping their insurance over time. This seems to me like a particularly nasty trick to cause whole life policies to lapse as people age.
Incidentally, you paying a lot of life insurance premiums, and then you dropping the insurance because it gets too expensive or your needs change, so the company never pays you out, is a key business strategy of the whole life insurance business.
Deductible: This is the amount of loss out of your own pocket you will suffer before the insurance company covers the loss. With homeowner’s insurance, for example, a $1,000 deductible means that with a $25,000 roof repair due to damages, you will be reimbursed $24,000 because the first $1,000 is on you. A $5,000 auto insurance claim with a $500 deductible means that you’ll receive a check for $4,500 to reimburse you for automobile damage, the net amount after your deductible.
As a rule, the higher your deductible, the lower your premium. This makes business sense because the insurance company is obliged to pay out less money to a claim, so will charge less money for the insurance.
As a general wealth-building finance rule, for certain kinds of mandatory insurance policies—like auto insurance and homeowner’s insurance—the best financial bet is to choose a high deductible, because it will lower your premium.
Your ability to choose a high deductible, in turn, depends on your financial strength to endure a loss.
If you have, say, at least $5,000 in savings in the bank, you can afford to choose the $1,000 deductible for an automobile accident. If the rare accident happens and you need to pay the first $1,000 for repairs, you won’t be wiped out getting your car fixed. By contrast, if you have little savings or you run a credit card balance every month, you probably need to choose the $100 deductible. Your insurance will cost more, but you’ve got to do what you’ve got to do.
Over a lifetime you will pay far more for auto insurance if you choose the low deductible. So, high deductible insurance policies are an example of the “the rich get richer,” because with lots of money in the bank you can afford to have low-cost insurance and save the premium money. This principle applies to renter’s or homeowner’s insurance as well. Choosing the high deductible will likely save you money in the long run, as long as you can afford it.
This principle of choosing the high deductible follows from the number one risk transfer rule of insurance: if you can afford the loss, then you don’t need to transfer the risk. Just keep the risk of loss, which you can afford, and save your money.
Coverage: Insurance policies generally have a maximum coverage amount, which is basically the highest amount the insurance company could possibly pay out when the unlikely bad event happens. In the case of auto insurance, the coverage for loss of the automobile will probably resemble the replacement cost of the vehicle, maybe in the tens of thousands. Similarly, for homeowner’s insurance, your coverage amount will be around the cost of replacing your home, which might run hundreds of thousands up to millions (should you be so fortunate).
For personal liability insurance, such as the unlikely event that you hit somebody with your car, the coverage could be in the hundreds of thousands to millions, and should relate in some way to your net worth. The more money you have, the more you could owe, if found negligent.
The main thing to think about on coverage is matching it to the financial risk.
What I mean by that is this: try to avoid paying too much for overly generous coverage. Insurance is too darned expensive to buy more than you need. It’s not clever, for example, to pay for $500,000 in homeowner’s insurance if your house and household stuff are really only worth $300,000. Could you lower your insurance costs by updating the insurance company on the (lower) cost of your car or home? If that allows them to shrink the coverage, then maybe.
Exceptions and exclusions: Have you ever read an entire insurance policy? Me neither. Do you really know all the exclusions or exceptions in there? Mmm, well, me neither. Insurance companies always specify, in the fine print, which unfortunate events trigger their payout and which don’t. I know there are many exceptions and exclusions in the insurance I purchase, but I frankly don’t have a full grasp of them. As a result, it is difficult for me to advocate—from a hypocritical place—that you study this deeply. But you can know that there will be exceptions and exclusions, and that you should ask the person selling the insurance to tell you what they are, in plain language.
If the exceptions and exclusions of your policy don’t fit your expectations, you may have to pay extra to get certain events included. Or you may have to seek out a secondary policy to get all your risks covered.
The Special Case of Life Insurance
On life insurance in particular I hold these truths to be self-evident. First, don’t buy too much coverage. Second, buy “term” life only, not a “whole” life policy.
Let’s say you’re 27 years old, in a committed relationship, with no kids, a dog, and a decent job. How much life insurance coverage do you need? How about …
None?
Your partner will take the dog. You have no kids to support. If your earnings potential ends abruptly because you got hit by a train, who exactly needs the financial security that you were supposed to provide? The answer is probably nobody. There’s no particular risk to be transferred. Of course, your situation could be special, but I don’t generally think you should feel—as a 20-something—that your sister or parents or unmarried partner or roommate deserves a financial windfall upon your death. That’s not your responsibility.
OK, fast-forward 10 years. You are married at 37, have two kids aged 4 and 7, a healthy spouse working part-time, an elderly dog, a mortgage (with 27 years of payments remaining), and a decent job. The way I figure it, the main financial risks of your death include the kids’ needs through college and the mortgage. Unless you suffer from very high lifestyle costs, you don’t need a $5 million life insurance policy. I think you need less than $1 million, maybe far less.
The right approach, I think, is to secure enough temporary financial relief to cover your spouse and kids while they adjust to life without you. If your spouse moves to full-time work in the event of your death, that’s probably OK. If your kids readjust their expectations from private college to state school, that’s probably OK, too.
Look, most people don’t die around age 37. Your financial focus should be building savings and investments that will help your entire family regardless of whether you live or die. All the money you spend monthly on life insurance premiums will—hopefully—be wasted.
You should not be paying to provide a windfall in the event of your death. Rather, you should pay a minimum amount for a partial safety net as a risk transfer—plus a rock-solid savings and investment plan for life—as you plan on living for a long time. Be optimistic here.
Let’s fast-forward again, to age 47. The dog has gone to his final resting place, your teenage kids are winning spelling bees and designing underwater drones at the science fair, while your spouse now works full-time, and you still have your decent job. Your mortgage still has 17 years to go. The way I see it, you have precisely 8 more years of life insurance risk to purchase. I say 8 years because that’s when your youngest graduates from college at age 22. That’s it. You need less than a million dollars of coverage.
Again, you’re not looking to set up your spouse and kids in luxury when you tragically choke on that jalapeño poppers appetizer. You’re looking to transfer the catastrophic loss-risk of your lost income, so that your family has time to recover. Yes, you still have significant mortgage debt. But after owning your house for 13 years, your family could decide to downsize the house without taking a loss on the sale. That’s not a financial catastrophe. Your smarty-pants kids do need some financial security to plan on attending college. But adjusting downward the cost of college is also not a financial catastrophe. It’s a manageable risk. Insurance is best when bought for the unmanageable risks.
Time flies, and you’re 57. The kids don’t live at home, two kittens have replaced them, and you have a small, 7-year mortgage left on your house. Your loving spouse is back to part-time work, and you enjoy your decent job. How much life insurance do you need now? At this point, would you believe …
None?
I mean, the kittens can return to the shelter from which they came. Your 24-year-old isn’t your responsibility anymore. Seven years left on your mortgage means that the majority of your house is paid for, and the monthly payment no longer consumes so much of your monthly costs. Ideally, you have appreciable retirement funds and maybe other assets so that your spouse will not be left penniless when you collapse at the CrossFit gym from excessive double-unders and burpees. Your spouse—if the same age as you—can begin collecting Social Security as early as 5 years from now.
Remember, insurance is a risk transfer. If you have some measure of wealth by age 57, the fact that you can’t earn income anymore isn’t a big risk for your spouse. If your family is relatively prosperous by the time you’ve turned 57, you’ve self-insured! Your death is terribly sad. Your death is untimely. But if you’re somewhat wealthy, it’s not a financial risk that needs to be transferred through life insurance.
Look, I understand I’ve described a somewhat idealized situation. Divorces happen and they are expensive. Adult children have a habit of becoming dependents. You bought a second home—with a big 30-year mortgage—because you are an idiot and a glutton for punishment. Your car isn’t paid off yet. You lost your job so the savings went away, and now you’re 57 and broke again. I get it, maybe nothing I described in my timeline worked out the way you wanted it to. But guess what? Those are unfortunate developments, but they are not really solved through life insurance. In fact those are all unfortunate developments better addressed by investing decades of your surplus money (all those insurance premiums that went unspent!) to build a real investment nest egg through the magic of compound interest, as more fully described in Chapters 4, 7, 9, 13, 14, and 15.
Resist the temptation to purchase insurance as a wealth-building tool for after you die. Insurance is one of the worst ways to try to build wealth.
This is all a long-winded way of repeating the lesson: in order to get wealthy, don’t buy too much insurance.
The second piece of advice—specific to life insurance—flows from the first: buy “term” life, not “whole” life.
Term life insures your dependents for a set number of years and then goes away. I describe the time line of ages 27, 37, 47, and 57 because I think it helps illustrate the age-specific life-cycle reasons to purchase insurance as a risk transfer. Premiums for term life tend to be fixed for the term of the insurance. The younger you are, the lower the premiums. As you get older, you will pay higher premiums for term life insurance. If you have specific risks to transfer when in your twenties, thirties or forties, term life insurance can be purchased relatively cheaply. Ideally, you don’t need life insurance once you’re older, because you’ve accumulated enough savings and investments that you’ve self-insured through personal wealth. That will save you from spending money on unnecessary and relatively more expensive term life insurance, when you are older.
Whole life promises to pay your dependents when you die, whenever that is. For most of us, statistically speaking, this will be when we’re relatively old. With whole life insurance you agree to pay an annual premium to the insurance company for the rest of your life. For high-quality whole life policies, you can lock in a fixed premium for life at the time you first purchase it. Some people (not including me) believe this means you should buy whole life insurance when you are young, to lock in that low annual premium rate.
I have a whole bunch of problems with whole life insurance.
One problem is that risk-transfer needs change over time, so we shouldn’t lock in purchasing insurance for the rest of our life, without knowing what future needs might be. As we get older, our need for a risk transfer should actually lessen. Our dependents, hopefully, are no longer dependent, but rather independent, adults. Our savings and investments, hopefully, provide some financial comfort to a loved one when we die. The safety net of Social Security picks up the care for our elderly surviving spouse. Medicare kicks in, lowering the costs of health care.
I mean, if you’ve done it right, you don’t need life insurance as a risk transfer once you’re old. You’ve self-insured by building up savings and investments. And the great news is that you can actually use that money anytime you want. You don’t have to die to, you know, be wealthy.
The next problem with whole life is that it commonly includes a provision for “accumulated value” (this is mixing the risk-transfer and investment functions—avoid!) and for “borrowing against accumulated value” (this is mixing risk-transfer, investment, and debt functions—avoid!). This violates both the original rule on insurance—risk transfer only—as well as the more general rule of this book, which is to keep things as simple as possible.
A further problem is that some low-quality whole life policies—especially ones advertised on daytime television with celebrity endorsers—charge annual premiums that may increase as you get older, on a 2-year or 5-year schedule. This encourages you to stop paying and let the whole life policy lapse.
In my description of the uses and abuses of life insurance, I haven’t taken into account the estate planning or the small-business continuity-planning role of life insurance. But let’s briefly discuss.
Estate Planning
Some large life insurance policies get bought by or sold to wealthy families as a tax efficient way to pass on significant wealth to heirs. By paying hefty life insurance premiums before death, for example, a family patriarch could theoretically pass on tens of millions of tax-advantaged dollars to heirs. I am not an expert in this type of life insurance. If this is available to you and your family, then clearly you can afford to find someone who is an expert in this type of life insurance. Also, if this is available to you and your family, you don’t need a book (like this one) on how to grow your wealth. You mostly just need a book on how to preserve your wealth. That’s a different book.
Small-Business Continuity
“Key man” life insurance covers the catastrophic loss to a business of a business owner or key business leader, without whom the business may suffer. Like estate planning, I file this exception under the category of “get expert help beyond this book.” I do think you should start your own business if that fits your personality (see Chapter 21), and then you might need key man life insurance, but that’s a specific scenario. Most households don’t have this issue.
Lowering Your Insurance Costs
With some effort, you can usually lower what you pay for insurance, whether for your auto, your home, or otherwise.
First, of course, putting one company into competition with another company likely improves your chance of getting the best price available to you. It’s probably a smart idea to check on your premium rates every few years. If you started out with a poor driving record but then manage to string together some accident-free years, chances are that a little rate competition will lower your auto insurance this year.
In addition, if you build up savings and a little bit of wealth so that you have the ability to financially self-insure against sudden losses, you should ask about your deductibles and raise them. Your premiums will drop significantly, leaving you with more money in the bank.
Assume insurance companies aren’t dumb and that they won’t misprice your insurance. They do, however, look to lower their own risks, which they will reward by lowering your premiums.
So, ask the provider about certain behaviors or situations that you may qualify for. You may be able to rule out or create exclusions that suit you. As an example, let’s say your renter’s or homeowner’s insurance automatically carries a $25,000 jewelry rider, insuring you up to that amount against theft, loss, or destruction of property. If you don’t have valuable jewelry at home and you don’t intend to ever get any, ask them what you could save per year if that $25,000 jewelry clause were eliminated. Can you get $100 back on your premium? The insurance company is happy to reduce its risk, and you’re $100 richer every year. Everybody wins. Look for this kind of thing specific to your situation.
Investing Rather Than Insurance
Finally, let’s review a bit of math regarding self-insuring through investments, rather than through whole life insurance. The math of compound interest—my favorite topic—kicks in here.
One way—the way I don’t advocate—to insure your loved ones is to buy $1,000,000 of whole life insurance beginning at age 30 at an estimated cost of $334 per month, or about $4,000 per year. How does that compare to just investing that amount?
Beginning at age 30 you could choose to pay $334 per month to your insurance company for the next 45 years until, let’s say, age 75. All along the way, your whole life policy would pay out $1,000,000 in the event of your unfortunate death. If you do not die, however, the life insurance policy by age 75 cannot be exchanged for any value. You cannot enjoy any fruits of your consistent and prudent payments. Instead, you must continue to make payments on it, for the rest of your life, just to have your heirs eventually get that $1,000,000 death benefit. Fail to make a premium payment along the way, and the policy lapses and you’ll get no benefit at all.
If you had decided to invest the $334 per month, and managed to earn a relatively realistic 6.25% annual return on those investments, your account by age 75 would be worth $1,001,121. I did that calculation in my spreadsheet by adding up a series of future values of $334 per month, at a yield of 6.25%. After studying Chapter 4 carefully, I know you could do the same math. And yes, I picked a 6.25% return because that led almost perfectly to the $1 million result, to make my math example pretty.
The advantage of this $1,000,000 investment account, obviously, is that you don’t have to die to enjoy it. It’s your money for the spending. If you die immediately, at age 75, you will, of course, leave the proceeds to your heirs. Just like a life insurance policy. But you don’t have to. I recommend instead that you buy a Harley Davidson and just start driving in any direction you choose. Why not? It’s your money, not the insurance company’s money.
Even better, at any point before age 75, you could decide to make a different plan with your money. In my view, self-insuring through consistent investment beats whole life insurance every time.
What about term life insurance?
Let’s say alternatively that starting at age 30 you buy a series of 10-year term life policies. At age 30 you buy 10 years of $1,000,000 of coverage, you renew that at age 40, and then again at age 50, and then you stop purchasing life insurance. This, by the way, is not a bad plan. It takes you through age 60, at which point hopefully most of your dependents have left the house and you’re merely responsible for a couple of dogs and a goldfish. Your death would be sad, but not a catastrophic, financial risk. Your spouse, hopefully, can draw from retirement accounts and Social Security in the coming years.
Let’s say these monthly premiums cost $21, $29, and $75 to purchase per month, at age 30, 40, and 50. Those are low, but reasonable, 10-year term life rates I took from competitive online quotes.
Let’s further assume, for comparison purposes, that you don’t die and your 30 years of term life premiums go “wasted.” The future value of all those insurance payments, by the time you are 75, and assuming a 6.25% return, would reach $86,062. On the downside, you’ve “wasted” your money because you didn’t die (note: that’s actually an upside). But financially, forgoing just $86K is a much cheaper option than the whole life policy. That’s a reasonable price to pay to transfer financial risk from you to an insurance company. Which is the whole point.
Even if you continued to purchase term life for another 15 years after age 60, at monthly premiums of $214 for 10 years and $609 for 5 more years, your accumulated value would only reach $177,854. I don’t recommend that, but compare it to whole life. It still beats the cost of the 45 years of monthly whole life insurance, which costs essentially $1,000,000 for a $1,000,000 death benefit.
Some would argue that, if I’m going to buy term life insurance for 30 years, between ages 30 and 60, that I should just lock that in at age 30, because the premiums will be lower. Maybe. I might be able to get 30 years of term life for about $60, beginning at age 30.
The reason I’d personally choose instead to renew each decade is that my insurance needs may rise, or they may drop, decade upon decade. If I have a $5 million net worth at age 50, for example, I’d argue that my risk-transfer needs have disappeared. I’d no longer need to buy any life insurance. Conversely, if life became unexpectedly more expensive or I acquired many more dependents, I may need to buy more coverage in a subsequent decade. Revisiting the issue of term life every 10 years allows for flexibility and adjustment to life’s needs.
Really Unnecessary Insurance
Finally, I hope that by pointing out the number one question about insurance—“What’s the risk-transfer need?”—you will know how to avoid unnecessary insurance products, like whole life insurance. What else can you avoid?
Most product warranties. You buy the $500 electronics product. The salesperson wants to sell you the $35 warranty. But, what’s the risk? Can you afford a $500 loss on that electronics product? Of course you can; you just spent that amount on an electronics product. I mean, you won’t like to lose it. You won’t be happy when the product fails. But it’s not really a big financial risk for you personally. As a result, you don’t need the warranty.
Optional insurance at the car rental place. Do you drive a car and have auto insurance yourself? Yes, you do, which means you have most personal liability for accidents covered. Do you have a credit card? Most often, through that, you have additional auto coverage for car rentals. As a result, you may have very little financial risk to insure. Very probably, you don’t need optional auto insurance at the car rental place.
The list of unnecessary insurance goes on from there, as the insurance industry figures out additional ways to extract premiums from us based on our emotions and fears. Try to resist. Or at least, try to really test in your mind whether you have a big financial risk that you need to transfer away from yourself to an insurance company. If it’s not a big risk, save your money. You will get wealthier in the long run.