When is insurance good value for money?
Almost all of us have some sort of insurance, for our houses, our cars, or even our pets. But it’s really hard to tell if any or all of it is a good deal. How can we tell if it’s worth taking out insurance.
To do this you need to understand four things about the insurance contracts you buy:
1. What you are insuring against (the “risks” we are insuring).
2. What the consequences of those “risks” are.
3. What the insurance company would pay in those circumstances
4. What you are really buying when you buy insurance.
Understanding what risks you are insuring
Make sure you know exactly when the policy will pay out and when it won’t. Don’t assume you know, make sure it’s shown to you in black and white. Whoever is selling you the policy has to make this clear to you, so make sure they do their job.
For example if you have buildings insurance for your home, understand whether what risks are covered. Does it include hurricane and storm damage? Does it include flooding? Does it include subsidence or other problems with the foundations? Does it cover damage to other neighbour’s property if you are liable?
Many people get stung because they didn’t understand what they were insured against and what they weren’t. They assumed that because they had insurance they were covered and didn’t bother with the small print. Don’t get caught out like that!
Whoever is selling you the insurance must be able to tell what is and crucially what isn’t covered by your policy. Make sure you know.
Understand the financial consequences of these risks.
In other words make sure you know roughly what it would cost you if any of these things happen. Of course you can’t know exactly but you need a ballpark idea.
Taking the buildings insurance example again, if your house burned down how much would it cost to rebuild it? I don’t know but I’m sure it would be more than I have in savings.
On the other hand if you had insurance for your toaster, how much would it cost to replace that? I expect most of us could afford to replace a toaster out of our savings or general spending without it causing us a major financial problem. If so, there is little point in insuring. (I’m talking about a specific toaster only insurance here, not covering your toaster as part of your total contents.)
Understand what payout you would get
Having insurance is no use if, when the worst happens, it doesn’t pay for all or most of the cost. It’s important to understand what payout you would get and how it would be worked so you know if it is enough for your needs.
Insurers often include an “excess” amount on a policy which means you have to cover the first small part of the cost yourself. They do this for two reasons: firstly to stop people making really small claims which would be costly to process, and secondly to make sure that you have some “skin in the game”. The insurance company wants to make sure that the
There may also be conditions about whether the things insured as replaced “new-for-old” or if they are valued as second hand. It might also specify if the insurer will arrange repairs or replacements or whether they will provide you with money for you to arrange it yourself.
Understand what you are buying
When you buy insurance, you are buying certainty. Certainty that if a bad things happens you will get at least a chunk of the cost back. That certainty costs money. In fact, on average, thinking about it as an “investment” you will lose money on insurance. But that doesn’t matter. It’s not about making money. It’s about protection from being wiped out, for example your house burning down and not being able to rebuild it.
I’ll say it again it doesn’t matter that insurance company does better than you on average, what you are getting is the value of the certainty. It’s not about "winning a bet". Otherwise you'd be disappointed if your house doesn't burn down.
Life insurance and annuities are a kind of insurance
Life insurance and annuities can be exceptions to these as well. These products do insure you against the risk of dying without being able to provide for loved ones (life insurance) or living so long you run out of savings (annuities). But often they include some investment linking or other which means that you also have to consider whether they are a good return and if they are a suitable investment for you in your circumstances.
Putting it all together
So buying insurance or extended warranties for cheap items you could easily afford to replace is unlikely to be a good deal (assuming the insurer has priced it properly, and to be realistic they have much better data than you do).
On the other hand insurance is a good deal if:
1. Covers you for something there is a realistic but small chance of happening.
2. What it covers you for would have a seriously bad effect on your finances.
3. The cover is enough to pay for most or all of your potential loss.
4. It’s not something you could easily pay for yourself (e.g. out of savings).
5. The certainty it offers is valuable to you, ie it offers “peace of mind”. How important this is to you will vary from person to person.
Like everything in investing (and in life!) there are exceptions. For example some forms of medical plans, which are mostly a way of smoothing your costs with an insurance backstop in case of disasters. But for most types of insurance you might consider buying these five questions will let you know if insurance you are offered is a good deal or a waste of time.