Tuesday, June 8, 2010

Are you Over-Insured?

Most Americas are over-insured for trivial things and under-insured for major liabilities.

Chances are, if you are like most Americans, you are over-insured. Middle-class Americans live in fear of losing what little they have. As a result, they pay thousands of dollars in premiums every year to cover contingencies that are total long-shots. Moreover, most middle-class Americans over-insure petty assets, while ignoring larger liabilities.

Most insurance is sold using fear tactics – for only a few dollars a day, you are protecting yourself from horrid possible outcomes in life. And what they claim to sell you is “peace of mind”. Like the extended warranty people, when someone says they are selling you “peace of mind” – watch out! Because an intangible like that is not really something you can put a price on.
Want real “peace of mind?” Then stop obsessing about material things and worry more about spiritual ones. Because once you reject materialism, you can have true piece of mind. Losing a car or a house won’t bother you as much. Trust me.

Most people have four types of insurance, Auto, Home, Health, Life and Liability. Let’s explore these and understand how much you actually need, as opposed to how much they want to sell you.

1. AUTO: Most people live in paranoid fear that their car will be wrecked, stolen, damaged or otherwise destroyed. Americans place an undue emphasis on the automobile in their lives, giving it an almost human-like quality, and often making it the centerpiece of their daily living. Let’s face it, we’ve designed our entire country around the automobile.

So most people put collision, comprehensive, towing, car rental, and other insurance coverage on their cars, often costing $1000 to $2000 a year in additional insurance costs. Is this a good value? I think not.

To begin with, if you think that what is parked in your driveway is a “major asset” that you cannot afford to lose, then chances are, you own too much car for your income bracket. A decent late-model used car can be had from anywhere from $10,000 to $20,000, depending on how fancy you want to get.

So-called luxury and sports cars are generally a waste of money and less reliable than more pedestrian makes. Yet, many middle-class Americans buy (or worse yet, lease) $30,000 to $50,000 cars, convinced that they can “afford the payments”, while ignoring the overall vehicle ownership cost over their lifetime (enough to fund a luxurious retirement at age 50).

If you really want to save a pile of money over the years, buy a car you really can afford, which means a car you can afford to walk away from if it is wrecked, stolen, catches fire, or whatever. A good used car that you pay cash for, does not require collision and comprehensive insurance – and is inexpensive enough that you can just shrug your shoulders if it is wrecked. If you can’t afford to walk away from the cost of what is parked in your driveway, you own too much car for your income bracket, period.
And the threat of losing your car entirely is far overstated. Most accidents are on the order of fender-benders, which can be inexpensively fixed (particularly if you shop around). Rarely is a car totally wrecked, and even then, a “totaled” car is just a car where the repair costs (at retail rates) exceed the book value.

Consider two adjacent neighbors. One buys a brand new loaded Camry for $30,000 and pays for $500 deductible collision insurance. The other buys a secondhand 3-year old Camry for $20,000 and pays cash. At the end of five years, both have used cars, but one has paid less than half the amount in insurance and depreciation. The difference is enough, in fact, to buy a second car. Or add $50,000 to your 401(k) at retirement.

Compounding this is the add-ons that insurance agents like to sell – rental car insurance, towing insurance, etc. that seem to cost only “pennies a day” but add up to hundreds, if not thousands of dollars over your lifetime. Again, as I have noted before in this blog, the idea that a car accident should be like an all-expenses-paid spa vacation is utter nonsense and a waste of money. Yes, it would be nice to have everything “covered” – but you pay for this, over the years. Nothing in life is free.

2. HOME: Homeowners insurance is a necessity. Partly because the mortgage companies require it, and partly because your home is a large asset that could be severely damaged in a storm or fire.
But many people have a lot of homeowners insurance – perhaps more than they need. Replacement cost coverage, contents coverage, glass breakage, low deductibles, all add up to higher premiums. Sure, it is only a “few hundred dollars a year” for the extra coverage. But add this up over time, and you are spending thousands over your lifetime for insurance that you will likely never file a claim on.
House fires just aren’t that common. That’s one reason why homeowners insurance has relatively low premiums relative to the amount of coverage. Compared to car insurance, it seems like a bargain. You may have $300,000 in coverage on your house, and $20,000 of coverage on your car, and the cost about the same. But a car is on wheels and far more likely to collide with things than your house.
One way to lower your homeowners insurance cost is to go to a higher deductible. Many people have deductibles as low as $500 for their homes. This means that they are more likely to file claims on small mishaps rather than take their lumps and move on. As a result, more claims equals higher premiums. Again, this may be “only” a few hundred dollars a year, but over a decade or more, this could be thousands of dollars in added premiums.

And most homeowners are likely to NEVER file a claim in their lifetime. And penny-ante claims for broken windows are more than offset by the added premiums for low-deductible coverage. Is a $99 broken window claim worth the additional $5000 in premiums over a decade? I don’t think so.
The main idea in insurance should be to prevent catastrophic loss, not cover losing your car keys. So if your house burns to the ground, yea, you want to be able to rebuild it, or at least pay off the mortgage and sell the lot and move on. A high deductible ($10,000) policy will cover you there. If your house burns to the ground, chances are, you can afford to walk away from $10,000 in contents coverage, or pay $10,000 toward its reconstruction.

I’ve had friends who have experienced house fires, and with low deductible policies, they describe it like a vacation. Nights in hotel rooms paid for. Reconstruction to better-than-new, all paid for, and all new furniture and possessions. They end up better off than before. And you wonder why more people don’t burn down their homes.

And yes, some do, on purpose, because insurance companies do make it so lucrative. In the recent housing downturn, some have resorted to arson to get out from under homes. And that’s one reason these “cradle to grave” policies are so expensive.

I presume you are not an arsonist, and thus not interested in committing insurance fraud. Why subsidize those who do by buying a low deductible policy? Taking a risk – a calculated risk – that your house will NOT burn down (which it likely won’t) is a better option. A high deductible policy will still cover most of your losses if the worst case scenario happens. But in the MORE LIKELY event that you never file a claim, you may end up with an additional $20,000 in your retirement account when you retire. Which is better? Betting on Armageddon and being broke at retirement? Or being more of a risk-taker and being assured of more money when you most need it?

3. HEALTH: Of course, this topic has seen a lot of press lately. In the past, since health benefits were not taxed, many unions pushed for more complete health coverage, as it was a way of obtaining increased compensation without paying taxes.

The problem with so-called "Cadillac" plans, and even some of the "Chevy" ones, is that since the patient pays for little or nothing, they tend to demand more services. And since doctors make money on services, they can prescribe them, since "no one" is paying for it. Cut yourself shaving? Better get an MRI. Funny, thing, too, the doctor owns a piece of the imaging center he sends you to.

When the cost of a service or product is totally disconnected from the user, the user has no interest in reducing costs or keeping costs reasonable. This alone is the reason the cost of health care has skyrocketed in this country in the last few decades. The few feeble attempts at containing costs have backfired badly, when doctors were encouraged to deny care and patients died as a result.

What is the ultimate answer? That is probably beyond the scope of this article. If you have a good health care plan, good for you. Use it and appreciate it. But bear in mind that every dollar you receive in health care benefits is probably a dollar less than you'd get in your paycheck. Nothing in life is free, and if your employer has to pay $1000 a month for your Cadillac plan, then that is $1000 a month less he is paying you.

The issue will likely solve itself in coming years. Like defined-benefit pension plans, full health care benefits are going the way of the dinosaurs. Young people today have 401(k) plans or IRAs, whereas their parents had pensions. And many young people today have to get their own health insurance or pay for a good part of it at work. The "good old days" are going away.

(And for those who are retired with defined benefit pension plans and full health care, watch out. Because when the company you worked for, for 30 years, goes bankrupt, your pension and health care will turn out not to be so assured after all).

For people like myself who are self-employed, obtaining health insurance and paying for it can be a nightmare. The basic mistake most people make when buying their own health care coverage is to try to replicate the full-service plans they had while working as an employee for someone else. We all want $500 deductibles (or no deductibles), $10 co-pays, and prescription coverage. But to get that, you may have to spend thousands, if not tens of thousands of dollars a year.

One friend of mine complains that he is spending $10,000 a year on coverage. He has a low-deductible ($1000) plan with lots of coverage. He and his wife are "afraid" to go to a higher deductible, like $5000 or $10,000. "What happens if we get sick? Where will we get $10,000???"

Well the answer is simple: You have to come up with $10,000 if you get really sick. Sounds daunting, but somehow, they are able to come up with $10,000 every year for the premiums on their "low deductible" plan.

In other words, you can worry about getting a small cut in your finances in the unlikely event you get seriously ill one year, or you can bleed to death slowly by paying for a "full service" plan every year, for decades.

If you are generally healthy and you do the math, you'll see that for any given year, the money you "save" with a lower deductible plan is more than offset by the higher premiums of such a plan. If the insurance company is paying out $1 in health care services, they have to charge their customers, on average $1.50 to cover costs and overhead. So yes, they might cover your dental visits ($98 each) but your insurance will be $500 higher (or more) for such coverage.

Again, the fear of getting ill is real to everyone. We all hear about the horrible things than can happen to folks who get seriously ill and are swamped with medical bills. But most of those stories concern people with no insurance whatsoever. And even with a "low deductible" plan, if you hit the "lifetime limit" in coverage, you run out of coverage, regardless.

Banking on getting sick, like betting on your house burning down or your car crashing, is never a good bet. Yes, you need insurance! The point of this article is not to say you need NONE. Only that you should assess what your actual risks are.

For me, the choice was simple. For each year I aged, my premiums went up. Between the age of 60-65, the premiums will be staggering, even if I am in good health. I will eventually HAVE to go to a $10,000 deductible plan at that point, as coverage would otherwise be unaffordable. Why wait until I am 60? Go to the high deductible now, and bank that extra money to cover the deductible in case I do get sick - or have it to spend when I am retired if I do not.

Self-employed people cannot afford dental or eyeglass coverage, period. And it is funny, once you start shopping on price, the prices drop dramatically - like by a factor of 4. The eyeglasses place that caters to the "covered by insurance" crowd, charges $450 a pair. The wholesale club charges $99. The Dentist who caters to the insured crowd charges $250 a visit for a cleaning (and suggests thousands of dollars of work, until you tell her you don't have dental insurance). The local dentist who treats cash patients charges $68 for a visit.

Yes, the ultimate solution to our "health insurance crises" is to somehow put people back in the driver's seat in terms of selecting and paying for coverage, while still making sure people are not denied treatment because of income. Good luck with that one.

In the mean time, we self-employed have to make decisions of our own.

4. LIFE: I have written on this before, so I will be brief here. When you are young and have responsibilities, such as a family, life insurance makes sense. A simple term policy is inexpensive, and if you die, your wife and kids are provided for.

But as you get older, the probability that you will die increases (until it is 100%, unfortunately). And as a result, the cost of insurance goes up. Eventually, like health insurance, it reaches a point where the premiums could bankrupt you. You either have to drop coverage or go broke trying to gamble on a "what if?" scenario.

Whole life, and various other investment-based scenarios are an interesting gambit, and I have tried all of them. But in retrospect, they were bad bets, as investment vehicles. I would have done better putting that money in my 401(k) plan or IRA.

Again, the situation can be summed up simply: You can go broke trying to insure a "what if" and then end up being destitute when the worse case scenario doesn't pan out.

It is like these "end times theology" people who are banking on the end of the world. What happens when it doesn't end? You've wasted a lot of time an energy and here you still are.

When you reach a certain age, you should have some money in the bank and your mortgage nearly paid off. At that point, you don't really need life insurance, as you already have assets to support your surviving spouse, should you die. And since the cost of coverage gets so steep, it will definitely cut into net worth over time if you continue it.

For example, when I was young, I had a $500,000 term-life policy through the American Bar Association. It cost about $400 a year. As I got older the premiums steadily increased, until at age 50, it was running about $2500 a year. Add to this the $500 in dues the ABA requires, and suddenly you are spending $3000 a year for coverage - a bet that you will die.

But the sad fact is, most of us will make it to retirement, and then need that $3000 to live on. Betting on worst case scenarios can end up causing a worse case scenario. Dying old and poor, but well-insured, makes no sense at all.

By the way, the same is true of disability coverage. Yes, it would be nice to get paid if you are disabled. But the premiums ($500 a month) are staggering, particularly as you get older. The odds of you being disabled between now and retirement are pretty slim, and if you are truly destitute, then you do have Social Security disability to fall back on (as well as your own assets). Eventually, disability coverage becomes wildly unaffordable, so it becomes only a matter of time before you are forced to drop it.
And again, like Auto, Home, Life, and Health, it is sold based on FEAR. As I noted in my postings"They're BAITING You!" and "FEAR", whenever you are buying something or taking any financial action (or inaction) out of fear, chances are, you are getting ripped off. Insurance, like Extended Warranties, is sold on fear. They tell you all sorts of horrible things than COULD happen, and for only pennies a day, you can insure against.

What they don't tell you is that, over time, those "pennies a day" turn into dollars a day, and by the time you retire, represent a six-figure number missing from your retirement account.

For further information on my experiences with different types of life insurance see My Experiences with NML after two decades.

5. LIABILITY: Part of your homeowner's and auto policies, of course, is liability insurance. this is the part that most people rarely think about, but in reality is their greatest exposure. If you wreck your car, the $10,000 it costs to replace it or repair it is not the big risk. The big risk is a lawsuit from someone you hit in the accident, or from one of the passengers in your car.

For example, a friend of mine's daughter got into a car accident, which killed her best friend, who was the passenger. A tragedy of huge proportions. Worse yet, the girl's parents sued for wrongful death for $1 million. If he hadn't had an umbrella liability policy, he likely would have had to declare bankruptcy and would have lost many of his assets.

Similarly, the big risk in your home is not it burning down, but someone slipping on the front walk and suing you when they break their back, requiring extensive medical care and then suing you for "pain and suffering". A $250,000 liability policy isn't going to cover that.

The exposure due to liability can dwarf the coverage for physical assets. And yet, many people opt for "cradle to grave" coverage for their home and car, but settle for minimum liability levels on their auto and home policies.

An Umbrella Liability Policy for $1 million or even $2 million or more can be had, fairly inexpensively, for about $200 to $700 a year. In terms of real exposure to real risk, it is very cost-effective and protects you from catastrophic losses.

And that is the key - catastrophic losses. Most people worry about trivial losses - losing a $10,000 car, or having to make a $10,000 co-pay. But then they blithely ignore a real risk - a million-dollar lawsuit, which they obtain no protection against, even though the cost is trivial.

If you have to buy insurance, buy it to help cover catastrophic losses, not pay for trivial consumer goods replacement.

Most Americans are over-insured for trivial losses and under-insured for the huge liability exposures.

* * * *

Over the last year, I have cut my insurance costs dramatically:

I dumped collision on all my cars, as well as comprehensive. I never had rental car or towing insurance. I got rid of the silly $10,000 medical coverage, as it covered nothing and most of my passengers have their own health insurance anyway. And I even dumped uninsured motorists coverage, as all it does is allow you to sue yourself. Risk taking? Yes. But it cut my car insurance from $3000 a year to $1000.

For my homeowners policies, I raised my deductibles to their highest limits and limited contents coverage. Risk-taking? Yes, but I am still mostly covered if a tornado takes out a house. Savings? Over $1000.

For my health insurance, I raised my deductible to $10,000. Like I said, eventually, I will have no choice in this regard. Savings? Another $3000.

I converted two of my whole-life policies to "paid up" life policies, and another pays for itself in dividends. I canceled my term policy, as my net worth is now over $1M and I don't need an additional $500,000 in coverage, at least not for $3000 a year. Savings? About $8000 a year, if not more.

Total savings? $15,000 a year, perhaps? This is a staggering amount of money for anyone. Many folks think that they can "afford" such coverage, as they are making $150,000 a year ("It's only 10% of my income, right?"). But as I noted in my Disposable Income blog entry, the amount of money you actually get to spend every year, once you take away mortgage, food, clothing, shelter, and other "fixed" expenses, is maybe 10% of your income.

So a savings like that nearly doubles your disposable income. Or put another way, it probably doubles the amount you can put away for retirement.

My only regret is not seeing this sooner. When I was younger, I merely assumed that the cost of insurance was fixed and that was the price I had to pay. I did not scrutinize costs and would assume blithely that I would just "make more money" down the road to pay for things.

As I get older and don't want to work as hard, these expenses start to make less and less sense. Betting against yourself is a zero-sum game. Assess your real risks and get an appropriate amount of insurance. Your greatest risk is retiring without enough money. You can't insure against that risk. The only solution is to fund against it. If you squander thousands every year to cover $10,000 risks, like your car or your deductibles, you will end up poorer in the long run.

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