Insurance – Elements 18


This post is part of the Elements series, a Periodic Table of all the Investing Elements that you need to take control of your financial life. You can find the rest of the posts here.


What is it?

Insurance is an investing Element with some unusual qualities:

  1. It’s the pooling of risk with others (via an intermediary).
  2. It’s a socialist element in a sea of capitalist elements.

It has something in common with ETFs and OEICs, where individuals pool their capital to share in the diversification rewards of investing in many underlying securities.

  • But instead of sharing in the upside, you are sharing in each other’s downside – the risk of an adverse future event – so that none of you is hit too hard individually.

It also has something in common with hedging stocks, via spread bets or options.

  • In both cases, you are looking to limit the downside.

And it has something in common with an Annuity, which is essentially longevity insurance.

Similarly, because there’s an intermediary involved, insurance isn’t always good value for money.

What kind of element is it?

We’ve classified Insurance as a Product, since that is how most people interact with it.

  • But since it deals with Risk rather than Opportunity – you use it to change your risk profile – some people might prefer to think of it as a separate asset class.

Who needs it?

There are two situations where insurance is a good idea:

  1. Where it’s legally required (to drive a car, or in certain occupations), and
  2. Where the potential loss is so large that you wouldn’t be able to cope with it (your house burning down, medical insurance whilst travelling outside the UK)

Smaller losses are best dealt with by self-insuring (taking on the risk yourself).

  • Over your lifetime, this will save you the insurance company’s profit margin on your premiums.

As well as large losses, some people with dependents will want to have life insurance, particularly in the early stages of their career, when they haven’t built up many assets that they can bequeath.

  • And some people will want disability or loss of earnings insurance.

What comes before it?

Insurance lies outside the usual track of plans, budgets and paying off debts.

  • You are likely to have completed a plan in order to have identified the risks that you might need to insure.

What comes after it?

Nothing directly – insurance stand alone as a risk mitigation product.

What age do you need it from?

Insurance is risk-related, not age related.

  • You need it as soon as you take on activities that legally require insurance (driving, certain jobs) or you acquire assets whose loss you could not accommodate from your own resources (a house).
  • Users of life insurance will need to acquire dependents before they buy.
See also:  Equities - Elements 21

These requirements point to a starting age in the region of 25 to 35.

What age do you need it until?

Again, the need is not age-related – you need insurance until the circumstances which led to you buying it no longer pertain.

So you might stop buying life insurance when your children reach maturity, and house insurance when your assets are sufficient to cover the loss.

  • In the case of house insurance, you’ll also need to have paid off your mortgage.

I still buy buildings cover, because my home is around 25% of my net worth, though in fact the cost of rebuilding it (which is what is actually insured) is substantially less, and something that I could probably cover from my own resources.

How much does it cost?

There’s no simple answer, though internet comparison sites have made it much easier to shop around for the best current deal.

  • My house insurance (buildings and contents) runs at around 0.2% pa of the costs covered (not the market value of my house).
  • Travel insurance for a short holiday might be 0.5% (though my 84-year old mother-in-law recently paid around 50% of her share of the cost of a recent trip in insurance costs).

The important thing to remember is that these costs contain a healthy markup for the broker and the insurance company.

  • In the long run, you will save money by not buying insurance.

What’s in it?

Insurance is a contract with a third-party that they will reimburse you if certain risks come to pass.

  • You pay a premium up front for the contract.

The insurance company pools the premiums and invests them.

  • If it has calculated the risks correctly, there will be money left over at the end of the period after all the claims have been paid.

What does a good one look like?

The internet has made insurance much more of a commodity item, so most people buy simply on price.

  • As always, the devil is in the detail, so you would be well-advised to check the small print.

You can often reduce your premium by agreeing to a larger excess (the first part of a claim that you must self-fund).

  • In the case of car insurance, you can go third-party instead of comprehensive.

What does a bad one look like?

A bad insurance contract is simply one that is too expensive for the risks covered.

  • Shop around.

Any recommended brands?

No – use the comparison sites each time you need to buy (and especially on renewals – insurance firms now operate the opposite of a loyalty scheme, where new customers get the best deals).

What are the main risks?

The main risk with insurance is that your claim is not covered, and therefore not paid out.

The second (much smaller) risk is that you pay too much.

How do you deal with these risks?

You can make sure that you have covered the correct risks by checking the small print (tedious, but necessary).

You can avoid overpaying by using the comparison sites.

Until next time.

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Insurance – Elements 18

by Mike Rawson time to read: 3 min