What It Means to Be Self-Insured

Every once in awhile I mention the concept of being self-insured as part of a post on life insurance. Quite often, someone will leave a comment like "what's it mean to be self-insured?" So I thought I'd write a post on the subject. It's not going to be an "everything you ever wanted to know about being self-insured" piece (do I ever write anything like that?), but rather a series of bulletpoints designed to give a quick but meaningful view of the issue.

Before I start, let me clarify that when I refer to "family assets" below I mean "net worth" -- the amount of value that's over and above any liabilities owed by the family. Having said that, here goes:

• Most people, myself included, buy life insurance to cover family expenses in case any of the family's breadwinner's or other members that provide "economic value" dies. This amount is designed to cover both living expenses as well as major one-time costs such as college education for kids and (sometimes) complete retirement funds for the surviving spouse. In our case, we have insurance on me to cover what the family would need if I passed away (since my job/income for the family would pass away at that time.) We also keep like insurance on my wife for an amount that would allow me to function economically if she wasn't there to handle the tasks she currently does for our family.

• The amount of life insurance usually purchased is generally dictated by this formula: total funds needed for family's provision = family assets + amount of life insurance proceeds.

• As you might imagine, when a family is young, family assets are quite low. In fact, they're often zero. In these cases, total funds needed for a family's provision is equal to the amount of life insurance needed. In other words, you have to buy insurance to completely cover your family's financial needs -- you can't cover any of the family's post-death needs from your current assets.

• But as time goes on, your family assets (net worth) start to build. Just follow my simple guidelines for getting rich and your net worth will increase steadily through the years. As the family's assets become larger, the amount you need from your insurance will decrease. And decrease. And decrease.

• Eventually, you'll get to the point where the total funds needed for the family's provision is equal to the family's assets. At this point, you're self-insured. You no longer need life insurance. As time goes on and your assets grow, your family assets will become much, much larger than the total funds needed for the family's provision. At this point you're not only self-insured, but you also have a nice cushion for safety.

For most people, the point where the family's assets equal and then surpass the family's need takes a long, long time to occur (if at all -- many will never really have enough to cover the family's need and they are left in big financial trouble if the breadwinner dies without any or enough life insurance.) For us, that point should happen in the next ten years or so -- about 15 years into a 20-year life insurance policy. At that point I can either keep the policy as a cushion of safety or cancel it (I'll likely keep it as it will be "cheap insurance" for someone in the last five years of a flat rate policy.)

One more thing to note: it's likely that the total funds needed for a family's provision will change over time. For instance, as children are added to the family, the total needed increases. As a larger house is purchased, the total increase. And so on and so on. As such, these higher levels of need will then require that either life insurance coverage or the family's assets (or both) increase as well. Just wanted to state that so no one thought I was implying that the total family need was static over a long period of time.

So, any questions, comments or thoughts? Anything you'd add that I may have missed or was unclear on?

Comments

[My Crossover Point]

I'd just add to what you said. Not only does the total funds needed increase, but it also decreases. I think it's kind of like a "bell curve" if you will. Early in life you're footloose and fancy-free, then you get married, have kids, buy a house. However as you get older you (hopefully) pay down your mortgage, your kids finish college, etc., and you don't have as much need.

Paul

[rxjohnk]

I think this often applies to areas other than life insurance. Auto, home, etc. Most governments (city, state, fed) and many large corporations are self-insured on their automobiles, property, casualty, etc.

Essentially, because their pool of covered entities is large enough, and their capital on hand high enough, they are better off NOT paying insurance premiums to a third party, but rather, keeping that money in house and paying out claims as they occur.

Many "self-insured" companies will have reinsurance to cover any losses over a specified amount over a given period, ($1 million per year for example), so that they can limit their financial liability.

[Trask]

There is one LARGE aspect that you left out. Some people buy life insurance to insure against taxation. For families that have a net worth in excess of 1 million or more they may face the dreaded "death tax" where the IRS comes in and takes half of everything.

The IRS however does not touch life insurance proceeds when paid out so it's a hedge in some instances.

[rwh]

For 2009 the estate tax begins at 3.5 Million. The rate up to 3.5 Million is Zero. The rate above 3.5 Million is 45%.

That all changes next year unless Congress fixes it.

http://www.statefarm.com/insurance/life_annuity/estate_plan/taxgone.asp

[rxjohnk]

I will never be "self-insured" with regards to life insurance. There are too many benefits to having permanent (ie-not Term) life insurance for me to even consider it.

1. Tax-favored use of cash value to finance my lifestyle that allows me to pay interest to ME not a bank.
2. Tax free to my heirs on my death. Death Tax can be as high as 43%!!! see more here: http://en.wikipedia.org/wiki/Estate_tax_in_the_United_States
3. My policy dividend grows my cash value by 6% per year... Even last year when the market was down 30-40%!

Only about 3% of term policies ever pay a claim, meaning that 97% of dollars used to pay for term insurance is wasted!

Compare that to the 80% of whole life policies that pay out. It makes you re-think all of those things that some people accept as fact, like "Buy term and invest the difference". That may be right for some people, but if it isn't right for you, wouldn't you like to know that now?

[Foobarista]

We don't do this for life insurance, but we do this for car insurance; we have enough cash set aside to replace either of our cars if we need to. Because of this, we have liability coverage only on both of our cars (although we have a lot of liability with a $1.5M umbrella policy).

[Foobarista]

Another element of "self-insurance" is not buying extended warranties. If you have enough money to replace your electronic gadget, you're effectively self-insured and don't need an extended warranty.

[MelMoitzen]

Isn't being "self-insured" just a nicer way of saying you're uninsured? Use one term, you look smart and analytical. Use the other, you're a reckless vagrant. It's a very fine line between the two.

[FMF]

Mel --

It's not the same the way I've described it. If you notice, in my description you have enough to cover all your family's needs in case you die. Not quite my definition of "a reckless vagrant."

[Param]

rxjohnk says: "Only about 3% of term policies ever pay a claim, meaning that 97% of dollars used to pay for term insurance is wasted!"
I think this is a gross misinterpretation of the relevance of insurance - which is nothing more than merging the art & science of probability...
The 3% policies that do pay out do not represent a mere 3% of premium paid in - the payout is based on sum assured, which is significantly higher than the premium (perhaps a multiple of 100 or so). 97% of dollars paid in compensate for the large payouts which are not in line with the premiums paid in. Of course, the insurance company's admin expenses & profits some out if this as well...

[LotharBot]

Foobarista is right on.

"Insurance" is a way to protect yourself against catastrophic loss that you can't afford. On average, you lose money paying into insurance, but it's worth losing a little to protect yourself from a crippling financial blow. But, IMO, it's not worth paying for insurance to cover "non-crippling" losses that you could actually afford just fine. Instead, just save up what you would've paid for insurance for various small-scale losses, and long-term you should come out ahead.

IMO, you generally should have life insurance, health insurance (not necessarily a "health plan", just catastrophic coverage), liability insurance (including auto insurance), and any other type of insurance required by law.

On the flip side, you should avoid buying insurance on consumer electronics (yeah, it sucks when your $300 stereo quits working, but it sucks even more to realize you've spent $1000 on insurance on similar types of electronics and only ever used it for the $300 stereo.)

In any case, you should make sure you have appropriate amounts of insurance. I recently realized I was paying $120 per month on collision/comprehensive on my 2 cars, which (based on expected replacement costs) means I'd have to total one car every four years to break even. Needless to say, I dropped that coverage and pocketed the savings. On the other hand, I made sure I had enough liability coverage that if I total someone's jaguar and put them in the hospital for a month, I'm not going to lose my life savings.

[Michael]

I have "heard" that instead of paying for liability insurance for your vehicle, you can post a bond for whatever the minimum amount of liability required. That way, YOU earn interest on your bond, not the insurance company. Anyone know different?

[FMF]

Michael --

Never heard of it. But maybe someone else has. I'll post you question in a week or so and see what others say. Stay tuned.