You Can Be Overinsured

An tornado ripped through my part of Dallas Sunday night, knocking the power out of my office building. As of this morning, they’re still not sure when the power will be turned back on. Judging from the number of electrical poles I saw ripped out of the ground, I’m guessing it will be a while.

Thankfully, my building wasn’t directly hit. Quite a few of the surrounding buildings weren’t so lucky. I drove by yesterday and the buildings looked like they had been shelled by heavy artillery.

This got me to thinking about insurance — specifically how much insurance it makes sense to carry.

Though I’m talking about home insurance, the same math applies to any form of insurance: auto, life, health, etc.

It’s possible to be under insured. That puts you and your family at risk of being wiped out if a tragedy were to strike. But contrary to popular belief, you can also be over insured and wasting money you could better spend or invest elsewhere.

Before we talk specific numbers, let’s get philosophical.

What Is Insurance, and What’s the Point of Buying It?

Insurance is effectively accepting a known loss in exchange for avoiding a potentially much more significant loss.

For example, your homeowner’s insurance bill might be a couple hundred dollars per month. That’s a known loss. You know ahead of time you’re paying it, and you do so gladly to protect from a potentially devastating loss were your house to take heavy damage.

But here’s the deal… Insurance only makes sense if the losses were potentially so great as to ruin you, or at least make a serious dent in your finances.

MY OFFICE 

My office is uninsured. Were the entire building to burn down, what would the risk be to me? I’d lose maybe a thousand dollars’ worth of furniture and maybe another thousand in assorted computer parts. My library would also be lost, but that’s harder to put a dollar value on since my books have sentimental value, as I’ve collected the books on four continents over two decades. But they have no real monetary value. Were my books to burn up in a fire or blown away in a tornado, I wouldn’t be able to replace them, even if an insurance company wrote me a check for their purported value.

In the case of my office, insurance makes no sense. I could replace it on a shoestring budget within a couple days. Why have yet another monthly payment to protect a bunch of junk that doesn’t really need protecting?

MY CAR

I have liability insurance on my car because it’s required by law and because I have no good way to calculate my risk. If I accidentally sideswiped a Rolls Royce and ran it off the road, I could be liable for hundreds of thousands in damages.

It’s better to pay Geico a modest monthly payment to avoid that possibility. But I declined full coverage. My car is paid for, and it’s pretty much a jalopy after carting around two young boys for seven years. If it were to get totaled tomorrow, I would view it as a blessing and buy something nicer. It wouldn’t be a major financial burden.

MY HOME

My home, however, is a different story.

It’s fully insured. Sometimes, I think it would be a godsend if the thing burned down. It’s been a money pit since I bought it. But if that were to happen, I’d still have a mortgage to pay, and I would potentially lose a couple hundred thousand dollars in home equity. Insurance protects me from that.

But, all the same, I have the highest deductible my insurance company allows because it means a lower monthly payment. I’m happy to accept the risk of minor damages in exchange for that lower payment. The money I save on insurance is used to pay my mortgage down faster, building my wealth.

So, How Much Insurance Do You Really Need?

And at what point does it make sense to “self-insure,” or simply accept the risk of being uninsured?

There really isn’t a firm number here. It’s more of a subjective feeling.

My rule of thumb is the “sleep at night” test. If you can comfortably sleep at night after considering your potential losses should the worst happen, you’re probably fine.

But let’s try to make that a little concrete.

Look at your current savings and ask yourself: “How much of that you’re willing to put at risk?”

If my car were to get totaled by an uninsured motorist, I’d need to have enough cash on hand to make a down payment on a new car. I’m good with that. But if you’re not good with that, then you should continue to have full coverage on your car.

Likewise, I’m comfortable eating several thousand dollars in home damages. My pain threshold is about $7,000 to $10,000. At that point, I start to sweat a little. So, I should have insurance that protects me after a deductible of roughly that amount.

And your number might be higher or lower. There’s no “right” answer here.

The Same Is True of Life Insurance

I want to have enough life insurance so that my wife and kids can continue to live our current lifestyle indefinitely were I to croak tomorrow. But I don’t want to have so much life insurance so as to give them an incentive to off me and make it look like an accident.

I’m joking, of course. All the same, it makes no sense for me to make massive life insurance premium payments for a ridiculously large death benefit when I could take that same money an invest it elsewhere.

Every dollar spent on unnecessary insurance is a dollar you can’t spend elsewhere.

So, this is my recommendation to you.

Do an honest assessment of your assets and look at what you’re paying (or not paying) for protection. Does it make sense? Or are you spending far too much money to protect something that might not be all that valuable?

If you have a healthy pot of savings built up, don’t be afraid to self-insure if you’re comfortable doing so.

Paying too much in insurance isn’t as potentially devastating as paying too little, but it is still detrimental to your wealth. It slows down growth and takes away from other potential investments that could bring in more money for you.