Saturday, July 2, 2011

Are you Risk-Averse or just Risk-Ignorant?

Many people gamble hundreds of thousands of dollars in the stock market without batting an eye.  But they freak out at the idea of not having $500 deductible collision insurance on their $10,000 clunker.

A reader asked me recently about homeowner's insurance.  I do not have any recommendations in that regard, merely suggestions on alternatives you should consider.  The ultimate decision and responsibility is up to you.

For me, I am a risk-taker, and the idea paying a lot of money every year for broken window coverage on my home or a low deductible just makes no sense to me.   If I can save hundreds, if not thousands of dollars a year by going to lower coverage limits, and a higher deductible, and tossing "broken window" coverage, I will.  Because if the house blows down, I still get most of my money back.  Maybe not all - but most.

But a lot of people are not comfortable with that - so be it.  That is their choice.  And don't go dropping your homeowner's insurance and saying I told you to do that - because I never said that.  That would be foolish.  And if your house blows down and you are not happy with the outcome, again, it is your choice not mine, that you made - don't go blaming me!

But people tend to focus on some risks while blithely ignoring other, greater risks, such a liability.  And people say they are risk-averse and "can't afford to lose" a $10,000 car, but are willing to gamble a quarter-million in their 401(k).

For me, I think the greatest risk we all face is liability.   If I run over a small child or crash into another car, the potential damages could be staggering - in the millions of dollars.  And most all of us are at exposure for this risk.  Granted, it is not a highly probable event (although it is nearly 100% certain you will be in at least one car accident in your lifetime, if you are an average American).  But if it does occur, it is a staggering event.

And yet, most people have only $300,000 in liability coverage through their car or their homeowner's policy.  And liability insurance is cheap.   An umbrella liability policy of $1 Million to $2 Million can be purchased for about $200 to $400 a year - pretty cheap.  And it covers both your cars and your house, and your boat, and all sorts of other liabilities (for example, you punch someone in the face in a bar).  $2 Million in coverage for a few hundred dollars - a lot of bang for the buck.

Most folks, however, have no such policy, but pay $200 extra a year to insure the windows on their house.   Or $1000 to $2000 a year to insure the bodywork on a $10,000 to $20,000 car.  These are expensive policies that provide very little coverage.  But most people perceive their risks in life as dented fenders an broken windows.

Similarly, with regard to big-ticket items, people freak out when I say that going to a $10,000 deductible on your health insurance or homeowners insurance is a good way to save money - if  you are risk-tolerant and risk-aware.  They argue "Where will I come up with the $10,000 if something bad happens?"  And of course the answer is, the same place where they come up with the extra premiums for their low-deductible health insurance or low-deductible homeowner's insurance.

High deductibles discourage nuisance claims -trivial nickel-and-dime stuff that drives up the cost of insurance for everyone, as some Joe Blow figures out he can get free carpeting if he claims that he had a chimney fire and the soot ruined the carpet.  But if you focus on the big picture - catastrophic events - and insure against those (and don't sweat the nickel-and-dime stuff of expect "freebies" from the insurance company) your premiums can be a lot lower.

But some people insist they cannot tolerate such a risk - that a few thousand dollars is a "lot of money" to them, and they can't afford to lose it.  This is a good argument, until you look at their investment portfolio.

To begin with, many have no portfolio, or have under-funded their retirement.  Their clunker in the driveway has its future assured, come hell or high water.   But the driver is not so lucky - he'll be sucking air long after the car is in the junkyard.

Others may have invested, but have no idea what their money is in - other than in a "mutual fund" of some sort - a company with a trustworthy sounding name that has a nice logo, a good jingle, and a compelling TeeVee ad with that actor guy - you know, the one with the trustworthy face.

But you can lose a lot of money in stocks, as we all recently found out.  And stocks can go all the way down to zero - ZERO and pay you nothing. 

And yet, many of these same risk-averse people who insure themselves to the hilt, think they can time the market and make money - stock-picking their way to success.  Or worse yet, they jump on bandwagons - or Gold or whatever is the hot tip du jure.

To me, this makes no sense.  In terms of risks, yes, I take some - and we all do.   If you have a 401(k) or IRA, don't kid yourself that you are risk-averse.  For my homeowner's insurance, I went with a higher deductible and less contents coverage.   If the house blows down, I should be made whole - or close enough.  But again, I don't view my house blowing down as a desirable event.

I dumped collision and comp on my cars - they are worth about $10,000 each.  It this risk-taking?  Perhaps, but bear in mind that my investment portfolio fluctuates by that amount every month - maybe more.  Last month alone, I gained, lost, and gained back enough money to buy a pretty nicely loaded Camry.  Sort of dumb to think ten grand is a lot of money when your 401(k) can go up or down that much in a matter of a few weeks.

Could things go horribly wrong?  Yes, I suppose.   If the house burned down with the cars in the garage, or worse, flooded (flood insurance coverage is usually less than fire or wind), I could end up in a situation where I would come out slightly behind.   I might not be made entirely whole, but most of the damages would be covered.  It is a risk.

But paying a ton of money to avoid that fairly trivial risk (with fairly long odds) guarantees another outcome - that I will bleed to death, slowly, over 30 years, paying $1000  to $3000 more for insurance.  That money, invested at even a nominal amount, would outweigh the higher deductibles or possible losses - making it a near break-even proposition.  And if the house doesn't burn down and the cars are not wrecked?  I come out ahead - way ahead.

Again, the choice is yours to make - think it over carefully and get out a pencil and paper and "do the math" and see how much you save going to a higher deductible or dropping collision, versus the potential risks involved.  And think about the other risks you are taking in life that are not insured at all, such as your investment portfolio.

It may turn out that you are not risk-averse at all, but just fail to perceive where your real risks lie.