This article started life as a debate between myself and Geoff Walters, the Universal Owl founder. We sat down to talk about insurance and quickly discovered our opinions on the topic were different.
Geoff thinks that as a commercial product, almost all insurance policies are a poor financial decision. I, however, think some forms of insurance can be a good investment and do make financial sense, provided you take into consideration the hidden cost of risk.
We’re presenting a summary of our discussion below to shed some light on the subject – is insurance a scam, or can it be a valuable investment? Hopefully, our back-and-forth will help you make a balanced, nuanced, and informed decision on whether paying for insurance products makes sense for you.
The Gambler’s Fallacy
Geoff describes taking out an insurance policy as akin to the gambler’s fallacy, which is the belief that the longer a statistically unlikely event goes without happening, the more likely it becomes.
For example: if a coin toss comes down heads five times in a row, there is an assumption that it has somehow become more likely that it will come down tails during one of the next couple of tosses. It can’t keep coming down heads, right?
It can, in fact. Potentially indefinitely. Each toss of the coin is statistically independent of those before it. There’s the same 50% chance of it coming down heads or tails each time it’s thrown, regardless of how many consecutive times the toss has landed on heads. It feels wrong to think about it landing on heads time and time again, but it’s just as likely to do that as it is to produce any combination of heads and tails.
This is exactly the same as insurance. Consumers assume that eventually they will have to make a claim, but it’s mathematically far more likely that they won’t.
Insurance Companies Always Win
The buyer’s assumption about the usefulness of insurance is just one part of the picture. The other is that insurance companies would not exist if they didn’t come out ahead. In other words, these businesses look out for themselves first.
The insurance business model is based on the statistical reality that most policy holders either never make a claim, or if they do, the payout is far less than the money paid in over the lifetime of the policy. The company will come out ahead, as the occasional large payout to a policyholder is more than covered by the many other policy holders, creating a healthy surplus for the company.
Because the insurance business model is built on the statistical reality most individual policyholders will lose money on insurance over the duration of their policy, says Geoff, it doesn’t make financial sense for any of them to buy insurance. They only do so out of fear, and because they are ensnared by the gambler’s fallacy.
From the perspective of the insurance policy holder, the most likely outcome is they will lose out financially from holding the insurance. The insurance company, however, always comes out ahead, much in the same way that the house always wins in the casino industry.
Geoff’s Case Against Insurance
Geoff asserts that insurance is, mathematically speaking, always a bad deal for policyholders.
Firstly, it is a mathematical fact that someone who doesn’t hold insurance is likely to have more money over their whole life (they aren’t paying it into an insurance policy). Secondly, any given individual would be better off investing the money they would have paid into insurance policies into risk-based investments like the stock market. By doing this they stand to make money off of that investment instead of losing it all to pay for the policy. They also lose the risk of the insurer finding a way to wriggle out of having to make a payment if the worst does happen.
Geoff is also concerned the insurance industry itself artificially inflates consumer prices. Companies providing services, like fixing a broken wall or cracked windshield, know they can charge more if an insurance company rather than an individual is footing the bill. This then feeds back into higher insurance prices.
Geoff wraps up his case against insurance with a couple of more philosophical points:
- As a firm believer in the abundance vs. scarcity mentality distinction, a defensive, ‘fear-first’ approach to money leads to poorer personal financial outcomes.
- Defending against a financial blow that probably won’t happen means forfeiting certain opportunities for wealth creation.
- The insurance industry creates codependent relationships where policyholders think “I can only survive financially if I have an insurance company”, thus giving those companies more power than is desirable. It would ultimately be better for the consumer to assume more self-responsibility.
Geoff personally only holds insurance when it is either a legal obligation or the regular payments are small enough that they “don’t register” for him financially. In the latter case he still reprimands himself that it’s a decision he made for emotional rather than logical reasons.
My Case for Certain Kinds of Insurance
As you know, I disagree with Geoff. I think holding insurance can be a financially sensible decision. Basically, it’s logical to take out insurance for events that, were they to take place, would materially change personal finances. Holding an insurance policy exchanges that risk for a set investment.
For most people, their home is their largest financial asset. Paying for good value home insurance cover doesn’t make a material difference to my standard of living or personal finances. Not extravagant cover that would pay for me to call someone out to fix a leak in my roof, of course. I can handle that. Just the kind of cover that would come into play if some event resulted in me suddenly and unexpectedly no longer having a house.
Cover for life-changing events like this is, I think, a sound investment. The same goes for life insurance, which I took out only because I have dependents. Losing my home or my family losing my earning power would have big financial repercussions. Paying into a well-chosen insurance policy doesn’t.
I do think a majority of insurance policies taken out by consumers are unnecessary, a poor financial choice, don’t represent value (a bad deal), or all three. I draw a firm distinction between insurance companies offering policies stacked in their favour to consumers who are not educated on how to shop around and assess value, and the argument that all insurance is a poor financial choice.
Historical Precedence for Insurance
Geoff’s argument that it can be mathematically shown that insurance is a poor financial decision doesn’t account for the cost of risk, which I think is just as important as monetary cost.
If the consequences resulting from a ‘black swan event’ are likely to be severe enough to change personal finances in a significant way, and assuming an insurance policy would not produce the same severe consequences, getting cover is a smart decision.
I think my reasoning matches up to the history of the insurance industry. Insurance is one of the oldest financial products in the world. Historians have evidence of insurance contracts being used by merchants as far back as 3000-4000 BCE Babylon. Ancient Romans belonged to ‘burial societies’ they paid into monthly, with members receiving a fitting funeral paid for out of monthly dues.
By the 15th century, maritime insurance had been well developed by Amsterdam’s merchants. The city’s wealth was to a large degree attributed to insurance’s role in smoothing out the vagaries of fortune out on the dangerous seas as goods were bought and sold around the world. Insurance meant talented merchants were not ruined by the bad luck of losing a particularly valuable cargo. And the whole city benefitted by this smoothing out of volatility and negation of the role of luck.
Good insurance policies made Amsterdam the richest city in the world for a period, because merchants from other cities relied on luck. Amsterdam’s took luck out of the equation and profited long-term at the cost of a majority of merchants paying more into mutuals than they took out.
In modern society, the stock market values companies more highly when it thinks there are fewer unknown factors that could significantly change the company’s future financial outlook. The stock market values certainty much more than very marginally improved finances. Because lower volatility has been statistically demonstrated to lead to higher returns.
Most Insurance Policies are Still a Bad Financial Decision
Having said all of the above, most insurance policies held by consumers today are, I think, as Geoff said, a poor financial decision.
One example: almost all insurance products sold with electronic items are a poor deal. There’s a strong argument that a careful person would lose out financially in the long-term even if they took out the best value deals on the market to cover pricier gadgets. If considering such policies, think about the value of gadgets you’d expect to lose to bad luck over 20 years, and the cost of insuring them all over that period.
Insurance products tailored for the over-50s notoriously offer poor value, as do specialist health and life insurance products, such as for cancer. In the case of the latter, a well-chosen general life insurance product would almost always be a better choice. Many insurance products represent questionable financial logic, too, and even more are just poor value and bad deals.
Even though I think there’s a good case for certain types of insurance being sound and smart investments, it’s not the case for all types of insurance. Even the worthwhile kinds need to be thoroughly researched and vetted by the individual.
Insurance as a Financially Sensible Step
I don’t think that insurance as a general concept is an all-good or all-bad affair. You have to examine individual policies and weigh the risk involved in both worst- and best-case scenarios, do the maths, then make a careful, informed decision.
I personally hold life and building insurance (plus those legally required of me, such as car insurance). I think those do make financial sense, as I researched my options and bought good value policies for my personal circumstances. Meeting their ongoing cost won’t have a meaningful impact on my family’s long-term financial circumstances. If circumstances went against me, not holding these policies would.
That means I’ll argue in favour of insurance as a financial product it makes sense to invest in. With all of the many caveats also mentioned.
I hope this argument offers a balanced discourse you can evaluate for yourself and reach a conclusion on.
What’s your take on insurance?