I recently saw a pretty sneaky TV commercial for an insurance product that I’d never heard of before. It’s called “return of premium life insurance.” It’s a form of term life insurance, and here’s how it works: You pay a monthly premium for a fixed term (like 20 years), and if you die during that time frame, your family gets a set payout (like $100,000). However, if you don’t die by the time the term is up, you get all of your money back — every penny you ever paid in.
Now, here’s the riddle: How could the insurance company possibly make any money on this? It sounds too good to be true, because there’s apparently no way for you, the customer, to lose anything. Either you “win big” by dying, and your family collects the jackpot, or you get all your money back. Where’s the downside?
Give up yet?
The trick to this scheme is that the insurance company invests the premiums you pay all along the way, making a handsome return on your money in the background. When it comes time to pay you back at the end of the term, they return your premium payments (which are now worth much less because of inflation), and they keep all the investment gains they made on the money you paid in.
Since most people don’t die during the policy term (or at least not very early in it), the insurance company makes a killing on aggregate. If that weren’t true, the insurance company wouldn’t be willing to offer the product.
But if you had just invested the money yourself instead of buying insurance in the first place, you’d be very likely to come out ahead financially overall. That’s easy to see with this specific example, but it’s actually true of virtually every type of insurance: car insurance, health insurance, dental insurance, homeowners insurance, renters insurance — they all work the same way.
This logic reveals a startling truth: Buying almost any type of insurance is a bad deal in the long run, statistically speaking*.
Don’t misinterpret that though. Most people need some amount of insurance. After all, insurance provides one important benefit — risk mitigation — very nicely. But understanding that it does so at the expense of long-term wealth-building will help you realize that buying less insurance can often be more financially responsible.
Note: We are not financial advisors. We’re just a couple of bloggers honestly sharing what has worked for us. This article contains personal opinions for your consideration, not professional financial advice. Check out our Disclosures page for more information.
Self-Insurance: An Alternative to Buying Insurance
How much insurance you need to buy depends on how much risk you’re willing to accept. And how much risk you’re willing to accept depends (in part) on how much money you have saved up. The more you have in the bank, the more you can afford to self-insure.
Self-insuring means that you skip out on buying certain insurance coverage, invest the money you otherwise would have put toward premiums, and simply accept the consequences yourself if something goes wrong. Let’s look at a couple of example scenarios to show how this can make sense:
First, imagine that you don’t have a penny to your name, and you rely on your $5,000 car to get to work. In this situation, buying collision insurance may be very important, because totaling your car would bankrupt you if you didn’t have the insurance company to replace it. That’s a risk you just can’t accept.
But now, imagine you have $50,000 in the bank and the same $5,000 vehicle. Totaling your car without a collision insurance policy** (while still sucky) would be no big deal to you. Yeah, you’d have to bite the bullet and pay for another $5,000 car, but you have more than enough cash on hand for that. Plus, you’ve been investing those foregone insurance premiums along the way, and you’ll continue to do so in the future. You’re actually getting richer over the long run by skipping out on insurance.
When to self-insure is a personal decision, and everyone will have a different comfort level, but the rules of thumb we’ve developed for ourselves go something like this:
- If we can afford to replace something ten times over without going into debt, then we don’t consider insuring it.
Example: My phone is worth about $150 on eBay at the time of writing this article. Since I have vastly more than ten times that amount saved, it would be pretty dumb for me to buy cell phone insurance. If I drop it in a toilet, I’ll buy a new one. Problem solved.
- If we can’t even afford to replace something one time without going into debt, then we’ll insure it (if it’s essential) or sell it (if it’s a luxury we don’t actually need).
Example: Even though we paid cash for our first house, we didn’t have enough money left over to replace it immediately if it burned down (at least not without doing gymnastics like tapping retirement accounts early), so it seemed like a good idea to buy homeowner’s insurance at the time — even though there was no lender forcing us to.
- Everything in between those first two extremes is considered on a case-by-case basis.
Example: In college, I bought a Honda Civic (with my parents’ help) for $5,600. A year or so later, I had managed to accumulate something like $6-8k in a savings account. By then, I technically had enough money to replace the car if it was destroyed, but it felt safer to carry collision insurance until I had a little more saved up (and a steadier income). I later dropped the coverage and have never bought it again since.
Three Types of Insurance Almost Everyone (Unfortunately) Needs
Insurance gives you safety and stability, but it also saps your wealth over time. It’s reasonable to want to eliminate as much of it as you can, but until we become multi-millionaires, there are three types of insurance we personally plan to keep around.
Health insurance is at the top of the list, which sucks, because it’s ridiculously expensive for semi-retirees like ourselves who have no employers to provide it. Despite its cost, we still buy health insurance because a medical catastrophe can bankrupt almost anyone. Paying $100,000+ per year for cancer treatment just isn’t sustainable (unless you’re Jeff Bezos or something).
With that said, we purchase as little health insurance as we can. We have a super high-deductible plan, which means that if something bad happens, we’re still on the hook for the first $13k(!) in medical expenses every year. Buying this crappy coverage lets us save on premiums, and we invest the difference so it will be there when we eventually need it. But be careful — we can only get away with this because we already have enough saved to pay that deductible many years in a row if necessary.
Liability insurance is also something we don’t go without, because getting sued is another thing that can bankrupt almost anyone in the worst-case scenario. Some forms of liability coverage (like the kind that’s included in car insurance) are required by law, so we don’t have much choice there anyway.
Finally, homeowners insurance is something we still carry, since our house is the most expensive thing we own. With that said, if the value of our house was less than 10% of our net worth, we’d probably drop it (at least the non-liability portion)! But that’s not the case for us yet. So we just buy as little coverage as we can get away with.
A Few Types of Insurance We’d Never Buy
Most legitimate insurance involves that tradeoff we talked about: safety and security vs. wealth-building. To some degree, it’s a matter of personal risk tolerance. But there are a few types of insurance that are a straight-up terrible deal like 99% of the time.
First off, whole life insurance is almost always a really bad buy. In a whole life insurance policy, only part of your premium pays for actual life insurance, which guarantees a payment to your family if you die. The rest goes toward an “accumulated value” component, where the insurance company is basically saving and investing your own money for you (minus a hefty cut for themselves, of course). If an insurance policy has any “investment” component built in, just run away. They’re usually terrible.
By contrast, term life insurance is alright, but it only makes sense if you have dependents (like kids) who would struggle financially without you. Once your dependents are financially secure, the benefits of a term life insurance policy are greatly diminished. And if you’re rich enough to leave a big inheritance behind, you probably don’t need any life insurance regardless.
Next, if you find yourself buying insurance for any consumer products or luxuries, take a second and reflect on why. Examples include smartphone insurance, travel insurance, and event ticket insurance. When you’re feeling the need to insure something that’s not a necessity of life, consider if you really need to have that thing right now. Could you wait until you have enough money saved that insurance wouldn’t be meaningful?
If you own a $1,000 smartphone, but you don’t have enough free cash to replace it multiple times over, you might be convinced that insuring it makes sense. But you should also think about just selling it and buying something cheaper until you’ve beefed up your savings. That’s the real power move.
And as much as we love to travel, we wouldn’t want to take a trip that was so expensive (relative to our savings) that we felt the need to insure it. We like to take big trips only because we’ve spent some time building a big bank account. Delaying spending until you’ve reached your financial goals will have a tendency to put you ahead. Just think about it.
Finally, extended warranties are glorified insurance plans that typically have much higher costs (relative to their value) than other types of insurance. When the cashier at Best Buy asks if you want an extended warranty on that external hard drive you picked up, it’s probably better to politely decline.
The Snowball Effect of Shrinking Your Insurance Bill
If you’ve been reading carefully, you may have noticed something bizarre: Rich people who could buy great insurance coverage are generally better off buying the crappiest plans (or none at all), because they have enough savings to self-insure. Meanwhile, people with no savings, who might have a tough time affording insurance, actually need its protection the most.
Since buying more insurance has a wealth-draining effect over the long term, a vicious circle can take hold: Those who need to build wealth the most are stifled from doing so by their need to insure against disaster.
Luckily, this vicious circle can be turned into a virtuous one by a reduction in household expenses and an increased savings rate. If you feel like insurance premiums are draining your wallet, try to slash your other recurring costs and optional bills as much as possible. Sell stuff you don’t need. Do whatever you can to start accumulating a cushion of savings and investments.
Everyone knows that savings grow through compound interest, but a second compounding effect can also emerge: Having more money on hand reduces the amount of insurance coverage you need, which means you can buy less of it, reducing your insurance premiums (and thus your expenses) even further — which means you can save even more!
Another way to break the cycle of insurance payments is to reduce the value of the stuff you need to insure. If you drive a $25,000 car, you may feel the need to buy collision insurance for a very long time. But if you sell that car and replace it with a reliable vehicle in the four-figure price range, you’ll feel more comfortable dropping collision coverage with a much smaller savings buffer.
Hack Your Way to Free Insurance with Credit Cards
With a little ingenuity, there’s always a way to beat the system, and insurance is no exception. There are a few types of insurance you can actually get for free through credit cards. Just make sure you’re using them responsibly.
Remember all those types of insurance we said were probably not worth paying for at all? Those are typically the types offered for free through credit card issuers. You just have to buy the thing that’s being insured with the card that offers the free insurance.
Travel enthusiasts like ourselves can score free rental car insurance coverage, certain types of travel insurance, and exotic stuff like medical evacuation insurance through credit cards. Aside from that, we’ve seen cards offering free extended warranties, cell phone insurance, and a whole bunch more. Just read the benefits sheets of the cards you already have!
If getting these smaller coverages for free helps you feel better about not buying them, go for it! It’s just one more way to claw some money back from the insurance companies and funnel it into investments (or debt payoff) instead.
The key to all of this stuff is to keep (and invest) as much of your hard-earned money as possible, taking managed risks without exposing yourself to excessive ones.
* This statement is made in direct comparison to the case where you wisely invest 100% of the money that you would have otherwise paid toward insurance premiums. If you plan to forego insurance and use the savings as spending money instead, you will probably come out far behind those who buy insurance! Another way of making this same statement, in statistics language, is that all insurance provides reduced variance (risk) to the customer, but almost always with a negative expected value.
** It’s illegal to drive without some amount of car insurance (typically liability coverage) in the United States. But “collision insurance” is just the part of a car insurance policy that reimburses you if your own car is damaged in an accident. It’s totally optional if your car is paid off.