Insurance

Personal finance is usually associated with investing. Often with budgeting. Sometimes with taxes. Insurances are a relevant part of the puzzle that is discussed less frequently.

As with investing, my understanding of how insurances work, and how they work for me, has changed through time. Here are a few lessons I learned so far.

I spent the last five years working for a couple of insurance companies and the capital allocation puzzle is a very fascinating one to solve. An insurance company can underwrite more insurance risk, the same type or different types, invest, hedge with re-insurance contracts or…return capital to its investors through dividends and stock buybacks. Leverage plays also an important part: how much debt they want to have and how the leverage profile varies in different phases of the cycle.

[/rant on

Dividend investors are a plague for insurance companies. Their love for constant (or growing) annual payments does not allow companies to build reserves “to be bold when others are fearful”. They force the business to pretend it is dealing with stable, predictable risks when the reality is exactly the opposite. I guess they never heard about a guy named Warren Buffett.

/rant off]

Underwriting insurance risks consume capital because insurance is a regulated industry. The regulator wants to be sure that each insurance company will be there when the policyholder presents a claim; for this reason, they force insurance companies to hold reserves against the risks they underwrite. It is the equivalent of the margin your broker asks you when you sell (write as they say 😉) an option.

If you combine this with the fact that insurance companies are for-profit entities, it should be easy to understand why underwriting risks is like an investment. An investment that has a quite high expected return, usually in the mid-teens.

Seen under this POV, it is quite amazing that while the insurance company expect to make 15% out of a product, there are many people who buy that same insurance thinking they will make a profit.

In my experience, this happens mainly with health insurance. True, there is an information asymmetry issue here, you know yourself and your circumstances better than the insurance company does (but most likely worse than Amazon or Facebook). But even in that case, leveraging that knowledge imbalance against someone who does that has their profession is way harder than you think.

Why anything pregnancy-related is seldom covered by standard health insurance? Because you have control over it. It is one of the few ways the policyholder can really leverage the information asymmetry. When it is covered, the insurance company makes a profit out of the higher premium charged, even if the policyholder thinks the added costs are negligible compared to the eventual benefit (they likely overestimate their chances of falling pregnant in a set period of time).

Another good example is kids’ dental insurance. Many parents buy it because “for sure soon enough we will use it”. Yes, there will be claims in the future to offset some of the premiums paid but…statistically speaking, the total premiums paid will be higher than the claims received. Way higher.

You should buy insurance only to cover risks that you cannot self-insure.

Dental insurance is like a reverse Buy Now Pay Later. Pay Now (in very small instalments) and Buy Later (the very expensive braces). Dental insurance avoids the shock of having to pay 6k in (almost) one go (almost) out of the blue. If you save and invest the premium, instead of paying it to the insurance company, you are (quite sure) to end up financially better even if your daughter ends up needing braces.

The issue is that few do that because few have the discipline (and the mental space) to manage that saving program. It is easier to pay the insurance, let them manage the whole thing and…convince yourself you are so smart when the eventual braces bill comes.

In most of the cases, you can be your own insurance company.

Peace of mind

I live in a country where people buy insurance on EVERYTHING. Really. Even if they are all bloody wealthy. And they mainly do this for “peace of mind”.

Managing your insurance company through saving and investing is indeed time-consuming.

Unfortunately, we live in a world where chasing insurance companies to pay legit claims is also time-consuming. Where is your supposed peace of mind now?

Insurance companies are built on an endemic conflict of interest: each claim paid out represents less profits for its owners. The insurance company has a very clear incentive to pay the lowest possible amount of claims. Even if the policyholder is in the right, they have to go through a certain level of obstacles, depending on the fairness of the company they are facing. The obstacles cannot be zero because the insurance company itself is targeted by fraudsters. Some of those obstacles are there to deter fraud, in a manner that is efficient and effective for the company…not for you.

Did you discount the “peace of mind” premium correctly? Can you even do it, given that you will learn how your insurance company behave only in the future?

If you rent in Switzerland, your landlord most likely requires you to buy personal liability insurance. I think it is personal liability, I didn’t even check it, to be honest with you and to show how much I (and you should) care: it is mandatory, I do it. One day, in a WhatsApp group I am part of, participants started debating on the cheapest personal liability option on the market. We are talking about a policy that costs less than 200 CHF a year (I paid less than 100 because…guess who I’m working for). What’s the cost opportunity you associate with your free time to spend part of it trying to save 20 quid?!? But here’s the kicker. Someone jumped into the convo suggesting to check if the chosen policy covers the costs to replace keys if you lose them. Now, not only you are wasting time reading a contract not even the guy who wrote it did…but in the future, you will have to chase the insurance company to get back…another 20 quid (it is Switzerland, anything can be out-of-this-world expensive)?

One of the worst insurance products is where you have to pay first and then chase the company for reimbursement. In this case, you can obviously fund the risk by yourself (you need to have the cash when the event happens), so instead of paying an insurance premium, you are better off with an emergency fund (even better, a margin account on IB as I explained in my previous post). The risk is represented by the temporal gap between your payment and the insurance reimbursement: the moment that gap exists, it invalidates whatever benefit the insurance offers. It is like receiving a margin call: doesn’t matter if later the assets you owned bounce back, the broker already sold them and you lost.

My father managed to stipulate another very stupid type of insurance: a health product that caps CLAIMS up to a certain amount. Like,the insurance company will pay max 40k. This is obviously (well, not to my father) the OPPOSITE of what you want as insurance. You want to self-fund claims that you know fit your budget (let’s say, in Switzerland, the classic 2.5k deductible) but be covered if it turns out you have a rare, curable but very expensive, disease. In other words, you want your insurance to have an uncapped liability towards you.

Which insurance you should buy

A good saving habit is what you need to cover all non-catastrophic risks.

Do not feel bad when you have to spend for them though. You feel good when you submit a claim to an insurance company because it feels like “free money” or a “return on your investment”, even if overall you are poorer (considering the premiums paid). If you self-insure, every time you pay you feel bad twice: first because something unpleasant happened to you (how unlucky!) and second because you have to reach into your savings to pay for it. Still, it is the better financial decision.

Catastrophic risks involve:

• Heath / severe loss of income, even if not permanent
• Shelter
• Death, but only when you have people depending on you

Health

We already discussed this. You should insure against events that would prevent you from generating income, temporarily or permanently. This obviously depends on your circumstances: it goes without saying that if you destroy your knee you face different consequences if you are a footballer or an actuarial. If you are an entrepreneur, you probably want stronger coverage than an employee.

This is probably the category where you want to spend a bit more, if it makes sense, to cover the “peace of mind” aspect. If your kid ends up at the hospital, the last thing you want to spend time on is figuring out how much is going to cost and how you are gonna pay for it. If you travel and spend holidays abroad, be sure you are insured with a company that has a proven global reach (and that you have the right policy, obv).

How far into the “left tail” you should aim to reach, i.e. do you want a policy that would cover your super rare disease that could be treated only by a guy in Seattle? I do not know. It is again a matter of costs and time. The farther you go on the left, the higher the premium: it becomes really hard to estimate if you are paying the right amount. And then you have to be sure that the policy you signed covers what you have in your mind. No policy is written like: “Pay this premium and we will cover whatever cost is needed to keep you alive”. You need to do research and most likely find someone you trust who is able to explain exactly what is going to happen. And then you have to research how prone to litigation is the insurance company offering the policy.

I had health insurance in Luxembourg and the UK, both were great (the UK provider was my employer too but I didn’t get any preferential treatment); cannot say anything about Switzerland because in almost 5 years, I just paid and never interacted with a doctor (which is good). That said, it is hard to generalise what “great” means.

In Luxembourg, the whole healthcare system was (is still?) free: the insurance covered for extras (I had surgery and they gave me a private room) and it was paid 100% by my employer. Would I have paid for it out of my pocket? I do not know.

In the UK, the premium was really cheap, less than 300 quid a month for the whole family (if I recall correctly) with an 800/year deductible. I started using it during Covid, meaning I was interacting with GPs, the first (useless for the patience) level, only via Teams calls, which is super convenient. Given the current state of NHS, I do not think I would ever stay uninsured there but…I also had one surgery and my wife delivered two kids, all under the standard NHS process and…it all went well, so it is (again) a matter of price.

There’s (maybe) one key conclusion: the number of times you are going to visit a doctor depends more on who you are than what happens to you. It is hard to say if my approach, never going to a doctor before 40 and after having a yearly thorough check-up, is the best strategy or if I just got lucky. I also never brought my kids outside the standard check-ups while I know parents that have a more intimate relationship with the paediatrician than with a gym but again, maybe I am too reckless…

House Insurance

Talking about prices, this is a very interesting case.

House insurance is the poster child of insurance you need to have. Well, if you have a mortgage, you have no choice. Your house is usually the biggest asset you own AND ALSO the place that protects all your belongings and yourself. Not insuring it would be insane, especially considering that if it gets destroyed you would (normally) not have the means to immediately replace it.

But…

Is this true at any insurance premium cost? If your house has a 5% probability of being toasted by a wildfire but the insurance costs 10% of its value, you should definitely auto-insure (i.e. put that premium aside for yourself rather than giving it to the insurance company).

Recently, house insurance premiums have exploded, partly due to inflation, partly due to the fact that climate IS changing and new risks are arising, partly due to the fact that insurance risks are like financial risks: sometimes investors (in this case, insurance companies) are greedy, and risk premiums get compressed, sometimes investors are fearful, and risk premiums get fat. Obviously, we are not yet in the situation of my example, premiums are not THAT high, but it is still a situation that deserves a thought or two.

If your home insurance is higher, and is going to stay so, because the risk profile of where you live has changed, maybe not paying the insurance is the right thing to do (for yourself). First, everyone around you is in the same situation. If something big happens (earthquake, flood, wildfire) the State will provide you a form of relief…because the State is…politicians, and politicians are elected by the people who got their homes destroyed. It is a a game theory-sh thing, if it happens only to you it is your problem but if it happens to the entire town, then it is a town hall issue. Sure, the insurance company would (hopefully) pay you faster than the State but in that case, you are getting back your money, while the non-insured would get your money as taxes you are going to pay (and paid in the past). And you have the unpaid premium saved.

Home insurance is meant for rare events, risks that are conceivable but very unlikely. But my thinking is related to the assumption that no one would want to live in a dangerous area, the “rational homo economicus” type of consideration. In reality, this is not what happens at all: people are more than happy to live in very risky places like Florida and California. When the risk changes from “if” to “when”, then you are better off finding the mortgage provider that accepts the lightest insurance coverage, keep your mortgage balance high and…hide your money when you declare bankruptcy? Just rent if you want to leave there??

If the insurance premium is small, sure the advantage of having money faster (and doing the right thing) is worth it. But when the price gets really high, I honestly do not know.

Death

If you are single, no kids and have life insurance stop reading and go watch Netflix.

Life insurance is a very important piece of the personal finance puzzle (combined with a will, depending on where you live). Unfortunately, life insurance is frequently sold in a product that combines two things: proper life insurance (i.e. your spouse/children get some money if you die) and a pension (i.e. you get some money in the far future if you do not die). I personally prefer to keep the two things separated.

If you have people depending on you, you should get life insurance. Basic life insurance is not complicated: you pay an annual/monthly premium and if you die, the beneficiary gets a lump sum. You can set the lump sum based on your circumstances and the higher it gets, the higher the premium.

Some employers offer life insurance as a benefit. In this case, the lump sum is generally a multiplier of the annual salary. The higher your family’s saving rate, the better this deal since the lump sum would cover a longer period; if you educated your spouse on portfolio construction and SWR they might be even set for life you are now single and the benefit is wasted unless you have kids.

Some banks offer mortgages with a life insurance kicker: if you die, they will consider the debt as paid. Setting the right lump sum amount depends on many things, like how much you saved for far. The older you get, the lesser amount you should insure, considering that, on one side, your savings pot grew while on the other, the premium got more expensive because you are older.

Life insurance is usually priced based on actuarial tables, meaning what is relevant is your sex (at birth) and your age. The only distinctive information you have to provide about yourself is whether you smoke or not. I have a pretty healthy lifestyle (regular at the gym, low meat/sugar/carbs, no alcohol) but I smoke one cigarette per day. Just one. I am the worst possible candidate for how the risks linked to these policies are evaluated. All things equal, the premium for a smoker is more than double the premium for a non-smoker. And my lone cigarette counts as the packs of a chain smoker. Smoking is an expensive habit, any way you see it.

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