Is Insurance a Rip-off?

A great question, and the answer is one of my personal favorites: it depends.

First off, it’s worth noting that insurance and extended warranties are basically the same thing. You pay some sort of fee in exchange for a promise that they will repair or replace whatever you are insuring. This makes sense in many cases, such as home ownership. Most people can’t afford to replace their entire house if it burns down, but they can afford to pay a few thousand dollars per year.

But instead of paying thousands to an insurance company, why not just save the money yourself and use it when you need to? And indeed, depending on what you’re insuring, you can do this!

If you wanted to, you could just put a few thousand dollars per year into a savings account, and then after a few decades, if your house happens to burn down, you can just pay for it out-of-pocket! No insurance paperwork required, no fees, no deductibles.

But there’s an obvious problem with that approach: what happens if your house burns down too soon, and you haven’t built up enough savings to replace it yet? That’s the benefit that insurance companies provide: they have so many customers that they can just pool everyone’s money together. Now they can afford to fix anyone’s house, at any time!* Insurance companies basically just spread out the risk of homeownership across all of their customers. This is where insurance really shines!

But insurance isn’t the perfect solution to everything either, because as it turns out, insurance companies have employees and offices and shareholders, and that means that they need to make money. So they take a cut. A pretty big one.** Just like with casinos, the house always wins.

Rule of thumb

So then what should you do if you want to stop wasting so much money on insurance? As it turns out, there is a basic rule of thumb you can use to figure out whether you should buy insurance for something or not.

• Insure anything important that you can’t afford to replace/repair on your own.

That way, you’re not wasting time and money dealing with insurance companies when you don’t have to. You get only the insurance that you actually need.

How risky are you?

That rule of thumb isn’t the entire story though. Based on the above, you might choose not to insure your phone because you can easily afford to replace it on your own. But what if you’re extremely careless and usually break your phone twice a year? Should you buy that warranty? In this case, you probably should!

This is because insurance companies charge you based on statistics. Basically, they calculate how often customers make insurance claims, then they charge enough in premiums to make sure that, on average, they are always making money. So, for example, if the average person breaks their phone once every 5 years and it costs $600 to replace, then the insurance company knows that they need to charge customers at least $120 per year (plus a little extra so they can make money). This is why car insurance costs more if you’re an 18-year-old man—because statistically, you’re a car crash waiting to happen.

But if you happen to know more than the insurance company knows about how risky you are, you can beat them at their own game! If you know that you break your phone way more often than the average person, you’ll probably end up spending less money over time by buying insurance. It’s cheaper to let them pay for your twice-yearly replacements than to pay $600 out-of-pocket every time.***

On the flipside, if you are extremely careful and unlikely to need an insurance payout, then over the long term, buying insurance will likely be a waste of money.

TL;DR: So should I buy insurance or not?

Most people SHOULD have the following types of insurance:

• Homeowner or renter’s insurance
• Health insurance
• Automobile liability insurance (legally required in most places)

Most people SHOULD NOT buy insurance on the following:

• Anything that you can put off fixing until later
  • So you probably do NOT need an extended warranty for a TV, video game console, dishwasher, etc.
• Anything you can afford to replace or fix on your own
  • Depending on your savings, this could mean your phone, your washing machine, etc.

You should CONSIDER insurance on the following, depending on your situation:

• Life insurance
  • Only consider if have you have dependents who rely on you, NOT if you’re single.
  • I recommend term life insurance over whole life insurance.
• Automobile comprehensive/collision insurance.
  • Basically only do this if you can’t afford car repairs/replacements.
• Travel/trip interruption insurance
  • Consider if you’re going on a trip that you would consider “very expensive”.
• Umbrella insurance
  • Consider if you have a high net worth and/or significant liability exposure.

*Sometimes, insurance companies actually don’t have enough money on hand to pay out insurance claims. This can happen during large natural disasters, such as hurricanes, where thousands of people all need money at once. Usually, insurance companies address this issue by getting “reinsurance” from an even bigger insurance company.

**It’s worth noting that insurance companies also make money not just from premiums, but by investing not-yet-paid-out money in various financial markets until it’s needed. Technically, it is possible for an insurance company to pay for all of its administrative overhead through investment gains, in which case, insurance would always be a “breakeven” deal. But I think this highly unlikely, so in most cases, you will be paying for that overhead in the form of inflated premiums, which means that insurance is usually a “losing deal” over the long term, unless you’re “lucky” enough to get a good payout.

***Note that if you make insurance claims too often, the company may recalculate your “risk profile” and start increasing your premiums or deductible to compensate for all the money you’re costing them. Some insurers may even cancel your insurance entirely if they think you’re too risky.