Insurance before wealth
Insure against risks that could ruin you; carry small ones yourself. A single uninsured major loss can wipe out a portfolio built over years.
Learning objective: After this lesson, you can assess which risks you should insure against before starting to build wealth.
Insurance isn't a product for the cautious, it's math. You give up a small, certain amount so a large, uncertain amount can't hit you.
The rule follows from that: insure what could ruin you. Don't insure what you can pay out of your emergency fund. A broken phone ruins nobody. A liability you're on the hook for over decades might.
Generally considered ruinous: damage you cause to others, the loss of your ability to earn an income, and, depending on your life situation, protecting dependents. These three come before any portfolio.
On the flip side, plenty of policies mostly feed the person selling them. If someone tries to sell you insurance and investing bundled into one product, be careful. Kept separate, both usually work better.
The decision framework is expected value weighed against probability of ruin. Insurance systematically has a negative expected value for the policyholder, since the insurer has to cover administration, distribution, and profit. Taking it out remains rational anyway when the possible loss exceeds your wealth: in that case, what counts isn't expected value but avoiding the absorbing state you can never recover from.
That's the same idea that reappears later in risk management. Someone who suffers a total loss has no return left to recover with. That's why avoiding ruin and maximizing return are separate goals, and avoiding ruin comes first. Insuring existential risks is this principle applied to your life rather than your portfolio.
On separating protection from investing: combined products bundle two purposes with different terms, different cancellation rules, and opaque cost structures. Kept separate, each part can be compared, switched, or ended on its own. The price of that convenience is a loss of comparability, and a lack of comparability is the most expensive state anywhere in finance.
Summary
- Insure what would ruin you. Carry what you can pay yourself.
- Protection comes before investing, because ruin can't be recovered from.
- Keep insurance and investing in separate contracts.
Did you get it?
Why is insurance rational even though it costs money on average?
Because it prevents a state with no recovery. For existential risks, avoiding ruin matters more than expected value.
What kind of damage shouldn't you insure?
Whatever you could pay for out of your emergency fund.
What's the problem with products that combine insurance and investing?
Both parts become incomparable, hard to switch, and opaque in their costs.
Check your understanding
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 ↗
Related
- Before you invest a single euroStage −1
- The emergency fundStage −1
- Goal and time horizonStage −1
- Matching questions for this stageQuestions