Insurance Basics Part 1: Understanding Insurance & Best Practices

The following is not financial or tax advice. Please consult a CPA or investment professional before making tax or investment decisions.

Insurance is a funny thing, you don’t think about it and you pay into it with no return until wham! one day you are hit by a literal or metaphorical bus and all of a sudden it is one of the most important financial decisions you have ever made. I am a firm believer in getting the right insurance policies that fit your risk tolerance and financial needs. The amount of insurance you have and the type of insurance you select can make a big difference in your life at critical junctures. The appropriateness of each kind of insurance will vary depending on your individual circumstances, but there are certain types of insurance that usually offer a better return on investment than others. This article is the first in a series will provide a detailed overview of every major kind of insurance. In this article I address basic concepts that apply to all forms of insurance and tips on how to approach buying insurance.

Terminology

• The National Association of Insurance Commissioners has a very comprehensive glossary of insurance terms. I cover some of the most important terms below in plain English. Each type of insurance has other terminology that I will outline in future articles.
• Beneficiary
  • The person or entity (trust or company) that receives the benefit from an insurance policy.
• Claim
  • Officially asking for payment or reimbursement for an insured event.
• Coinsurance
  • The percentage of costs a policyholder has to pay for covered services. For example, 80/20 would imply you have to pay 20% of the costs above your deductible.
• Deductible
  • The amount you have to pay before an insurance policy kicks in.
• Exclusions
  • Events or items that are not covered by insurance.
• Excess and Surplus (E&S) lines or Non-admitted
  • Higher risk, usually more specialized coverage provided by insurers that are not licensed by a state’s insurance department. If you live in an area with higher natural disaster risks such as Florida or California or you need coverage on a specialty risk such as collection of baseball cards, you may end up having to use an E&S insurer.
• Insurance policy
  • A contract that pays to compensate you or the beneficiary for a specific loss, liability, accident, property damage, or death.
• Liability Coverage
  • Protects you against losing money if you are found responsible for injuring a third party or damaging their property.
• Maximum out of pocket or Coverage Limits
  • The highest amount you have to pay for covered services during a given year you have insurance (plan year) before the insurer covers 100% of costs. 
• Premium
  • The amount you pay monthly or annually to keep a policy in force. 
• Property and Casualty Coverage
  • Insurance that protects you from damage, loss, or theft.

Trade offs and you get what you pay for

Insurance is fundamentally a tradeoff, you are foregoing money now in order to reduce the payout on a potential future expense. The insurer assumes the risk that the profit they make from collecting your premiums and investing it exceeds the cost of paying out claims by a healthy margin. Under less probable circumstances, insurance helps you avoid a massive payout if for example you get in a major accident, your house burns down, you have a serious health ailment, or you are sued for a boat load of money. In these instances, insurance stops you from going broke, what gamblers call, the “risk of ruin”. Under other more mundane circumstances insurance helps pay for medical care, minor accidents, and property damage.

The main tradeoff in insurance is the premiums you pay versus your coverage. The cheapest coverage isn’t always the best option and neither is the most expensive. The policy that provides you with the best amount of coverage relative to your premiums and with coverage that is commensurate with your risk tolerance is going to provide you with the most value.

Insurance and wealth

Your wealth is a major determinant in your insurance calculations. The wealthier you are the greater your ability to absorb risks without insurance that would bankrupt someone else. Conversely you also have a higher litigation risk if you get in an accident as people will see you as someone they can get money from. Therefore, paradoxically at some level of wealth your insurance needs evolve.

 If you have an 8-figure net worth and your house would cost $1m to rebuild, you probably want to minimize the dwelling coverage in your homeowner’s insurance. If the house burns down, using less than 10% of your net worth to rebuild it will have little impact on your life. (Charlie Munger famously said he doesn’t insure his homes!) Conversely, because you have a higher risk of litigation, you likely want to take out umbrella insurance in addition to maxing out the liability portion of your homeowner’s insurance. A person with a $100k net worth will likely want a greater degree of protection on homeowners and health insurance as a large enough catastrophe or health issue could bankrupt them.

Shop around, but make apples to apples comparisons

Most types of insurance have standard coverage amounts and deductibles that you can select from. However, they are not all exactly alike. When comparing insurance, make sure that you are doing an apples to apples comparison. One insurer may appear cheaper, but in actuality offers far less coverage. For example, when you are comparing an automotive insurance policy with comprehensive insurance make sure the deductibles, coverage limits, and excluded events are the same or similar.

Check for discounts

Insurers provide discounts if you are an alumnus of certain universities, member of organizations such as the bar association or fraternities, a servicemember or veteran, belong to a wholesale clubs such as Costco, or are employed by companies with whom the insurer has a partnership. Look on your insurer’s website for a list of affiliation discounts or ask your agent/broker for a list to see if you qualify. Some insurers also offer discounts for taking defensive driving courses or good student discounts for teen drivers.

AAA Geico Liberty Mutual State Farm

Review your coverage

Sit down with your insurance agent or broker and go line by line through your insurance to understand the point of each coverage. In the event you don’t have a broker, google every line, what the average coverage looks like and where you fall in relation to the coverage. If something makes no sense given your circumstances or is wildly expensive relative to the coverage being offered, cut or reduce it.

After the fires in Los Angeles I thought it was a good time to review my homeowner’s insurance with my insurance agent. I went through line by line and asked him to explain what each line covered. I learned that I was insured up to $2m of “personal property”. I don’t own $200k of personal property, let alone $2m. Reducing my coverage to $350k resulted in several hundred dollars of savings. I also eliminated several superfluous coverages that were completely irrelevant to our circumstances, thereby saving a few hundred more dollars.

Beware of minimum coverage requirements

Sometimes you have to carry a minimum amount of insurance because of state regulations or because another financial obligation such as a mortgage, lease, or loan requires it. For example, California has a $30k per person or $60k per accident bodily injury liability minimum for automotive insurance policies. Your mortgage may have a maximum homeowner’s dwelling policy deductible that you have to meet. Similarly, many car leases have minimum comprehensive and collision deductibles. My wife’s car requires a maximum $1k comprehensive policy.    

Brokers and agents

For more complex forms of insurance such as homeowner or director and officers it may make sense to use an insurance agent or broker. An insurance agent or broker may save you money in the long-term for the following reasons:

• Independent agents or brokers may have access to insurers you have either not heard of or who don’t quote individuals directly.
• They can help explain each form of coverage in your policy and recommend relevant coverage you would not have thought of yourself.
• Agents are likely familiar with relevant discounts that you may not be aware of.
• When a major claim event occurs rather than having to call a customer service line, you can call your agent who can help you navigate the process. Always be wary that agents are still acting in the insurer’s best interest.

There are two different kinds of agents, captive and independent. Captive agents work for one insurance company such as All State or State Farm. The advantage of a captive agents is they are likely very well versed in the insurer’s policies and can provide very detailed information. The downside is that they can only quote you for one insurer. Independent agents work with several insurers and therefore have the opposite advantages and disadvantages. They can quote multiple insurers which will potentially result in a lower price, but may not be as familiar with any single insurers policies.

Agents are compensated directly by the insurer, so their interests do not always align with your own. In some states such as California and Massachusetts they may have a “duty to advise” you meaning they have to do more than just procure the coverage requested, but in others such as Montana and Rhode Island no such duty exists. In some states agents owe a fiduciary duty to their clients, but not in every instance. As is the case with any intermediary whether they do or do not have a duty to advise or a fiduciary duty, always do your own homework and check to make sure they are not ripping you off.

Brokers are similar to agents, but there are a few key differences. Both agents and brokers are usually paid a percentage of your policy premium as a commission, but brokers can also charge fees on top of the commissions. Agents can usually “bind” your coverage, meaning they can activate and issue your coverage. A broker cannot. As mentioned above, with the exception of a few states, insurance agents generally do not have a fiduciary duty to you, rather they represent the interests of the insurer. Brokers have a fiduciary duty to consumers in some states. Although brokers are supposed to be agnostic on which product they choose, commissions will obviously have a bearing on which insurance they ultimately try to sell you. Always proceed with caution with both brokers and agents and if possible ask for details on their compensation.

There are also three primary kinds of brokers. Retail brokers work with individuals and small businesses. Most of the time the average person will work with them. Wholesale brokers are the next step up. They sell more specialized products and you may encounter them more often if you have a business or a niche form of insurance such as boat insurance. Surplus lines brokers provide insurance in amounts that are greater than standard or the “admitted” insurance market provides. They also provide more niche specialized insurance on more unique risks.

Insolvency and Ratings

The risk that the insurer doesn’t pay is very low, but something you should pay attention to. In the last 25 years 1,000 insurers have failed globally, however in the US over the last 10 years only 12 have failed. In the US when an insurer fails each state has a guaranty fund which plays a role that is similar to the FDIC for banks. Like the FDIC, guaranty funds have a maximum coverage amount (list of state maximums), for example, California has a $300k life insurance, $250k annuity, and $200k health benefit maximum. The risk that the guaranty funds will kick in is low given there will always be some cash from the insurance company’s statutory fund and usually insurance regulators try to get another insurer to take on policies. However, if you have a life insurance policy of $1m with a poorly rated insurer that goes down, there is no guarantee that even with the protections above, that you will be made whole.

To lower the risk of an insurer going under, look up your insurer’s AM best rating which is kind of like a credit rating for insurers. As can be seen below, the score is simple and follows grades, with an A+ being the best and D the worst.

Source: Bankrate

Asymmetry

Insurance is one of those rare instances where you know more than your insurer about the risk you present. There is an asymmetry of information that can give discerning insurance buyers an advantage that improves the returns on insurance spending in your favor. Although they have large actuarial models and understand you within the context of the insured population, insurance companies don’t know and couldn’t know a lot of critical details about you that can make a huge difference in your riskiness.

You may for example know that you park near a tree that has branches which are particularly prone to breaking on top of cars, so you get comprehensive coverage. Life insurance companies typically ask for your immediate family’s medical history, but not your grandparents who may have had major ailments. Similarly, you may love eating crappy food, but have been lucky to be skinny and healthy so far. All a life insurer will see is that your height, weight and blood tests are all within the acceptable range. Long-term care insurers usually don’t know if your grandparents had dementia given the spottiness of records prior to electronic health records. Terrible drivers that have been lucky not to have accidents will appear to be good risks to auto insurers.

Insurance vs Investing

Insurance should provide you with financial protection in the event a calamity occurs. It should almost never be an investment vehicle. There are exceptions with ultra-high net worth people that may use insurance for tax deferral and estate planning purposes, but the wrapping of insurance together with investing usually results in sub-optimal returns and higher fees. Fixed payouts through annuities are even worse if you enter an inflationary environment that rapidly erodes the value of your insurance. Think about how low in real terms (after inflation) your return would have been if you bought an annuity that pays 4% a year in 2019 when inflation was around 2% vs now where its closer to 3%, effectively halving your real return from 2% to 1%.