Self Insurance Explained
by Gary Foreman
Dear Dollar Stretcher,
In an article on life insurance I read that the goal is to be "self-insured". Can you give some guidelines on what that might look like. Assuming someone is debt-free, how should they figure how much they should have available in savings/investments to be self-insured?
That's a great question! Hidden inside the answer is a principle of insurance that can save you money. Also included is one of the toughest financial planning questions there is. Let's start at the beginning and see if we can't have some fun exploring life insurance. (OK, maybe we'll just keep it from being boring!)
We'll start by thinking about the purpose of insurance. All insurance is a method for handling large losses. Consider fire insurance. If your house burned down you'd probably have a hard time paying for the rebuilding and replacement of everything that was lost. If you own a fire insurance policy you've substituted a smaller known expense (your premium) for an unknown, potentially large expense.
Robert I. Mehr, in his book Fundamentals of Insurance, defined insurance as "a device for reducing risk by combining a sufficient number of exposure units to make their individual losses collectively predictable. The predictable loss is then shared proportionately by all units in the combination." In effect you've joined with a lot of other homeowners to put together a fund for the few unfortunate families that will have a fire.
But insurance is not the only way to handle the risk of loss. As Stephanie points out you have the option of 'self insurance'. Again, let's look to Mr. Mehr for an explanation. The "technique of spreading losses for a single entity over a long time span is known as self-insurance."
How does this work in our world? My favorite example is the extended warrantees that you're offered when you buy a big screen, tablet or most other appliances. I always turn them down. Why? Well, I'm spreading the small losses (the cost of the extended warrantee) over a long time span and using them to pay for the big loss (when our big screen dies). By putting the money in my saving account (and keeping it there) I'm acting as my own insurer or 'self insuring'.
There is one other way to solve the problem. That's to reduce the possible loss. Let's use auto collision insurance as an example. If your brand new car is totaled you'll be facing a pretty big loss. But if you destroy a ten year old car the loss is not nearly so large. So if you own an older auto you've reduced the risk of loss.
Before we get to Stephanie's question we need to do one other thing. That's discuss why we buy life insurance. The purpose of life insurance is to cover the expenses caused by death and the loss if income of the person that died. These needs change dramatically during a person's life.
A young unmarried adult or teen doesn't need much (if any) life insurance. Generally no one else is counting on their income. The expenses caused by their death are usually limited to funeral and burial expenses.
A young parent is a different matter. The remaining parent (or nearest family member for single parents) will have a whole host of expenses in raising that child. The dead parent's income would have paid for food, housing, clothing and education. Someone will need to pay for those things. Life insurance can be used to cover that need.
And you need to consider what would happen if a stay at home parent would die. Suddenly there would be a whole bunch of new expenses that aren't in your budget today. Replacing Mom with daycare is a major new expense. And there will be others, too.
Your need for life insurance will gradually decrease until you reach empty nest and retirement stages of your life. By then you should be at the point where no one depends on your income and the only concern is covering your funeral expenses.
So for Stephanie to be 'self insured' she'll need to save enough money to cover her needs. Now to do a precise calculation is beyond our abilities here. You really need to see someone who has software to handle the many variables. But let's see if we can give you some quick rule of thumb ideas.
You'll need enough insurance to cover your final expenses. The cost will in large part depend on what you want. But it's easier than you might think to run up a $20,000 bill. A quick call to a funeral home will give you a reasonable number or you can use the $20,000 estimate.
Add to that enough insurance to cover any additional expenses caused by the death. Take the day care example. If you thought that you would be spending an extra $2,000 each year you'd need enough insurance to generate $2,000 income. How much insurance is that? If you assume that the insurance could earn 5% you'd want $40,000 of insurance ($2,000 divided by .05).
Now to be really proper we have to admit that childcare expenses go away after a time. That's why software is necessary and this is just a rough guesstimate.
When you're thinking of extra expenses there's a lot to consider. You may be losing the household repairperson. It could be that someone will be needed to do housecleaning or cooking. You get the idea.
Next you'll need to add enough insurance to replace the lost income of our dearly departed. If you were replacing a $30,000 salary and assumed 5% interest income you'd need $600,000 of insurance ($30,000 divided by .05).
So for our made up person here we'd need $660,000 ($20,000 + $40,000 + $600,000). That's total life insurance from all sources including any employer paid plans.
Remember, we haven't considered inflation. That complicates this beyond what you really can do with pencil and paper.
While it's hard to come up with an exact number for Stephanie, it may be possible to answer her question without a whole lot of math. If you're single or married without children it's quite possible that you can save enough to be self insured. You'll need enough to pay final expenses and possibly replace the lost income so the survivor can keep paying the mortgage.
However if you have kids that are still dependent upon you for support you almost certainly need insurance. When you're finally back in the empty nest stage it's time to consider self insuring again.
The main thing is to think through your own situation. Death is a sure thing. It's the timing that's in doubt. You don't want to leave your survivors without sufficient resources to meet their needs. After you die is no time to find out that you needed more insurance.
Thanks again to Stephanie for a thought provoking question.
updated June, 2013
Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com. Gary shares his philosophy of money here. You can follow Gary on Twitter. Gary is also available for audio, video or print interviews. For more info see his media page.