How Insurance Works: Protecting Your Wealth

How Insurance Companies Make Money

Knowing the business model makes you a smarter buyer. Insurers earn from two sources.

• Underwriting profit. The gap between premiums collected and claims paid out. If a company collects $100 million in premiums and pays $92 million in claims and expenses, the underwriting profit is $8 million. Many insurers run near break-even on underwriting because competition keeps premiums down.
• Investment income, or “the float.” Insurers collect premiums today and pay claims later, sometimes years later. In the meantime, they invest the money. That pool of invested premiums is the float. Warren Buffett built much of Berkshire Hathaway on this idea: his insurance subsidiaries (GEICO, General Re) generated billions in float that he reinvested in stocks and businesses. The float is, in effect, free capital to invest, so long as claims are managed well.

You are dealing with sophisticated companies that use actuarial tables, historical data, and statistical models to make sure they collect more than they pay. On average, the odds favour the insurer. For the individual policyholder who suffers a catastrophic loss, though, insurance is the best deal in finance.

Health Insurance

The most important policy you will own. Medical costs are the leading cause of personal bankruptcy in the United States. A three-day hospital stay can run $30,000 or more. Cancer treatment can exceed $200,000. Without coverage, a serious illness can wipe out decades of saving in a few months.

The terms you need to know:

• Premium. Your monthly payment. Higher premiums usually mean lower out-of-pocket costs when you actually use the plan.
• Deductible. What you pay before the insurer starts paying. A $2,000 deductible means you cover the first $2,000 of medical bills each year.
• Copay or coinsurance. Your share of costs after the deductible is met. A 20% coinsurance means you pay 20% and the insurer pays 80%.
• Out-of-pocket maximum. The most you will pay in a year. Once you hit it, the insurer covers 100%. This is the number that protects you from a catastrophic bill.

If you are building wealth, choose a plan with a low out-of-pocket maximum. The premium difference between a low-deductible and high-deductible plan is often $200 to $400 a month, or $2,400 to $4,800 a year. That is far less than a $100,000 hospital bill would take out of your portfolio. If you are healthy and want to keep premiums down, a high-deductible health plan paired with a Health Savings Account is a reasonable alternative: you get a tax-advantaged savings vehicle alongside catastrophic coverage.

Life Insurance

Life insurance pays a death benefit to your beneficiaries when you die. You need it if anyone depends on your income — a spouse, children, an aging parent. You do not need it if you are single with no dependents.

There are two main types.

Term life insurance covers you for a set period, typically 10, 20, or 30 years. If you die during the term, the policy pays. If you outlive the term, the policy expires and pays nothing. Term life is pure insurance: no investment component, no cash value, just risk protection. It is dramatically cheaper than whole life. A healthy 30-year-old can buy $500,000 of 20-year term coverage for $25 to $35 a month.

Whole life, or permanent insurance, covers you for your entire life and includes a cash-value savings component that grows tax-deferred. Premiums run 5 to 10 times higher than term for the same death benefit. The cash value grows at a modest rate, usually 3% to 5% a year, and you can borrow against it. Insurance agents push whole life because the commissions are 10 to 15 times higher than on term policies (I've watched plenty of families get sold a whole-life policy they didn't need and couldn't really afford — the agent earned a year's worth of commission on a single signature).

For most people, term is the right choice. Buy term coverage for the years when you have dependents and financial obligations, and invest the premium difference in index funds or your 401(k). The investment returns are very likely to exceed the cash-value growth of a whole-life policy. “Buy term and invest the difference” is one of the more reliable pieces of personal finance advice.

How much coverage? A common rule of thumb is 10 to 12 times your annual income. If you earn $75,000, aim for $750,000 to $900,000 of coverage. That gives your family enough capital to replace your income for about a decade, pay off the mortgage, and fund future expenses like college.

Disability Insurance

The most underappreciated policy on this list. Your ability to earn income is your single most valuable financial asset. A 35-year-old earning $75,000 will earn roughly $2.25 million over the next 30 years, before any raises. If illness or injury prevents you from working, that future income stream disappears.

Disability insurance replaces a portion of your income, typically 50% to 70%, when you cannot work. There are two types:

• Short-term disability. Covers the first 3 to 6 months. Many employers provide this as a benefit.
• Long-term disability. Begins after short-term coverage ends and can run until age 65. This is the critical one. If your employer does not offer it, buy an individual policy.

One detail to watch: make sure the policy defines disability as own occupation, meaning you collect benefits if you cannot perform your specific job. An any occupation policy only pays if you cannot work at any job at all, which is a much higher bar. A surgeon who loses fine motor control in her hands can still work as a consultant under an “any occupation” policy and would receive nothing.

Homeowner’s and Renter’s Insurance

If you own a home, your mortgage lender requires homeowner’s insurance. The standard policy may not cover floods, earthquakes, or the full replacement cost of your belongings. Review the policy once a year and make sure the coverage limits match your home’s current replacement cost, not the purchase price or market value.

If you rent, renter’s insurance is one of the best deals in all of insurance. For $15 to $25 a month, you cover your personal property against theft, fire, and water damage, and you get liability protection on top of that. Your landlord’s policy covers the building, not your possessions.

Auto Insurance

Beyond the legal minimum, carry enough liability coverage to protect your assets. If you cause an accident and the other party’s injuries exceed your policy limit, they can sue you for the difference. Someone with a $500,000 portfolio and only $50,000 in auto liability coverage is dangerously underinsured. Raise the liability limits to at least $250,000 per person and $500,000 per accident, or higher.

Umbrella Insurance

An umbrella policy adds a layer of liability coverage, usually $1 million or more, on top of your auto and homeowner’s limits. If you have meaningful assets — a trading account, retirement savings, real estate — an umbrella policy protects them from a lawsuit that exceeds your underlying coverage. The cost is low: $150 to $300 a year for $1 million of additional protection. For anyone with a net worth above $200,000, an umbrella policy belongs on the list.

Insurance as Risk Management

Traders use risk management in the market. Insurance is risk management for the rest of life. The same principles apply.

• Insure against catastrophic losses, not small ones. Choose higher deductibles on health, auto, and homeowner’s policies. You can absorb the first $1,000 to $2,000 of a claim from your emergency fund. What you cannot absorb is a $300,000 medical bill or a $2 million lawsuit. Raise deductibles, lower premiums, and put the savings into adequate coverage limits.
• Do not insure what you can afford to lose. Extended warranties on electronics, phone screen insurance, pet insurance for routine vet visits — these are low-cost items you can self-insure by paying out of pocket. The insurance company marks up the expected cost by 40% to 60% to cover its expenses and profit. Buy insurance only for losses that would materially affect your finances.
• Self-insure more as your wealth grows. As your net worth rises, your need for some kinds of insurance falls. Someone with $2 million in liquid assets may no longer need life insurance, because the family already has enough capital, and may choose only catastrophic health coverage with a high deductible. The wealthy effectively self-insure small and medium risks and reserve insurance for truly catastrophic scenarios.

The Insurance Priority Checklist

If you are building wealth and need to set priorities, here is the order of importance:

1. Health insurance. Non-negotiable. The #1 financial risk for most households.
2. Disability insurance. Protects your income, which is your most valuable asset.
3. Auto liability. A legal requirement and asset protection.
4. Term life insurance. If you have dependents.
5. Homeowner’s or renter’s insurance. Protects your property and adds liability coverage.
6. Umbrella policy. Once your assets exceed about $200,000.

Building wealth without protecting it is like building a house without a roof. Things look fine for a while. When the storm comes, everything inside gets ruined. Put the right insurance in place, pay the premiums without complaint, and then stop thinking about it. Spend your attention on the things that build the wealth in the first place.

See also: Emergency Fund · Net Worth · Budget 50/30/20 · Warren Buffett · Position Sizing and Risk Management