Insurance before wealth
Insure what could ruin you financially. Carry yourself what you can pay out of pocket. A single large uninsured loss can wipe out a portfolio that took years to build.
Learning objective: After this lesson you can judge which risks you should insure before you start building wealth.
Insurance is a simple trade: you pay a small, certain amount so that a large, uncertain amount doesn't hit you.
The rule behind it
That leads to a clear rule. Insure what could ruin you. Don't insure what you could pay from your emergency fund. A broken phone ruins nobody. Damage you'd be liable for over decades does.
An example: Mia is cycling, doesn't see a pedestrian, and the man is permanently injured. Without liability insurance, Mia may be liable with all her assets and her future income. Her €15,000 portfolio would be gone quickly in a case like that.
What threatens your livelihood
Three things usually count as life threatening to your finances: damage you cause to others, losing your ability to work and, depending on your situation, protecting your dependants. These three come before any brokerage account.
Policies that pay the intermediary
On the other hand, there are many policies that mainly earn money for the salesperson. If someone wants to sell you insurance and investing in one product, be careful. Separately, both usually work better.
On average you lose money on any insurance, because the insurer has to cover administration, sales and profit. So the expected value is negative for you. It still makes sense when the possible damage exceeds your assets. Then what counts most is avoiding a situation you couldn't recover from.
Link to risk management
The same idea comes back later in risk management. If you lose everything, you have no return left to make it back. That's why avoiding ruin takes priority over maximizing returns. Insuring big life risks is that principle applied to your life instead of your portfolio.
Combined products
About products that combine insurance and investing: they tie together two purposes with different terms and cancellation rules, and their costs are often hard to see through. Separately, you can compare, switch and end each part on its own. Giving up that convenience gets you comparability, and that's worth a lot in financial markets.
Summary
- Insure what could ruin you. Carry what you can pay yourself.
- Protection comes before investing, because you don't recover from ruin.
- Insurance and investing belong in separate contracts.
Did you get it?
Why does insurance make sense even though it costs money on average?
Because it prevents damage you couldn't recover from. With such risks, that matters more than the average.
Which losses should you usually not insure?
Ones you could pay from your emergency fund.
What speaks against products that combine insurance and investing?
Both parts become hard to compare and switch, and the costs are hard to see through.
Check your understanding
Your task
Write down five losses that could happen to you, each with an estimate in dollars. Mark the ones that would exceed your emergency fund (work it out in the emergency fund calculator) or burden you for years. Note how you are covered for those cases today.
Sources and further reading
- Ole Peters and Benjamin Skjold (Ergodicity Economics, London Mathematical Laboratory) show why buying insurance can be rational despite a negative expected value: for existentially threatening risks, what matters is not the expected value across many people but avoiding ruin for one's own wealth over time. View source ↗
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