13. What is insurance good for? Part 1

I recently decided to cancel my comprehensive car insurance (leaving only the liability and mandatory insurance) and my personal property insurance. Together, these will save me about $1500 a year. I still have life insurance and long-term disability insurance through my workplace. Am I over-insured or under-insured?

If you ask any insurance agent, he'll tell you I'm under-insured. Of course, their job is to sell you as much insurance as possible. But when is it right for you to buy insurance and when are you throwing away your money?

To clarify the problem, let's take an example. Suppose you buy a mug at the store for $10, and they offer you an insurance: $5 a year against any damage, with no deductible. In other words, if you drop and break the mug, you'll get a replacement mug for free. Are you interested?

Sounds a bit ridiculous. You can certainly afford to buy a new mug if needed. The benefit of the insurance is insignificant, and though the cost is low, after 2 years you've already paid the entire cost of the mug. If the chances are you'll keep the mug for more than 2 years before you break it, this deal is bad for you.

What are the problems with this proposal?

First, statistically, it is biased towards the insurer. This would always be the case, but it's more obvious in this example. After all, insurance companies are there to make money. They have expenses - management, commissions, agents, buildings, processing, etc. And after paying all these expenses, they still need to make a profit. So of course, on average, they'll charge you for the insurance more than what, on average, it's worth for you. Again, this will always be the case. To make things worse, if you're a careful driver, living in a good neighborhood, in good health etc. then you'll be subsidizing a lot of people who have a much higher risk of using the insurance.

The second reason you would not want to buy this insurance is that the potential loss is not catastrophic for you. If you become disabled and cannot work for the rest of your life, or if you crash into a parking lot full of brand new Mercedes-Benz cars, the damage will be high, and it may ruin you financially. For these events, and only these, insurance is a prudent step. For anything that you can afford (such as, in my case, losing the value of my old Passat or buying new clothes and furniture), insurance is a casino bet that is tilted towards the house.

The third reason is that the mug insurance is too costly. A good insurance will have high deductible and low cost, and this mug insurance has no deductible at all.

To sum up, these are the questions you need to ask yourself when you're offered insurance:

• Is the insurance going to protect me against a catastrophic event that might ruin me financially, or against an affordable damage that I can pay for out-of-pocket without much hassle?
• Is the insurance going to cover all my expenses or does it have a low limit that will still leave me exposed?
• Does the insurance have a deductible high enough to lower its cost?
• What is the alternative to the insurance? How else can I invest the money?
• What are the chances I'll need this insurance? What will happen if I don't have it?

As another example, consider extended warranties. Every year I'm offered to buy warranty for the major appliances in my home. Each costs between $100 to $300. If I bought them all, I would spend about $1500 annually on insurance. Yes, they do break from time to time, but I never paid more than $500 in any given year to fix them. Again, the math is unquestionable - trust the actuaries to charge high enough premiums to make the house win.

Next week, on a real case analysis for a friend of mine who needed to weigh a much more costly insurance plan: $50,000 for long-term care.