December 1, 2013
I’m not a fan of gambling. There is one form of gambling, though, that I recommend for everyone — insurance.
How is insurance gambling? Well, let’s start with the easiest example to explain, life insurance. When you pay your life insurance premium every year you are saying, “I bet I’m going to die this year.” This is a bet, however, that I am sure you want to lose. If you live until the next premium payment, “the house” sweeps your bet in and you get nothing (setting aside cash value policies). Year after year you “bet” the premium and lose. One year, you will die before paying your next premium and you will hit the jackpot. Or, at least your beneficiaries will. This is a perfect arrangement. We buy insurance to protect us from risk. With life insurance, the risk is that a breadwinner will die when she or he still has people depending on her or him for income.
We usually refer to insurance “companies,” but they all started as “mutual” companies and many still are. “Mutual” means that we are all in this together. If 1 million 35-year-olds buy life insurance, the life insurance company knows, surprisingly accurately, how many will die in a given year. Basically, all those who live “give” their premium to the families of the policy holders who die that year. However, we all have to pay a fee for the life insurance companies to assume the risk, recruit policyholders and process the paperwork. A typical life insurance company pays out about 85 percent of its premium to beneficiaries. Consequently, if you buy life insurance and live to life expectancy, you will pay $100,000 in premiums (including investment earnings) for an $85,000 death benefit.
What if a 30-year-old woman and an 80-year-old man each come to you and say, “I want to bet you $1,000 if you will give me 100-1 odds that I will die this year?” I wouldn’t take that bet with the 80 year-old-man. Before I took the bet with the woman, I would want to know her health condition. What if I find out she had inoperable cancer? I wouldn’t be willing to pay $100,000 on that bet. Life insurance companies have learned to take only fair bets. If the 80-year-old man is in good health, the the insurance company might say, “We will take the bet, but only at 10-1 odds. If you want a $100,000 policy, your premium charge will be $10,000/year. Life insurance companies typically adjust the premium based on age (older people die more frequently than younger), gender (men die younger than women) and health condition (unhealthy people die younger than healthy).
Because the average person will only receive 85 cents on the dollar, we should buy the least amount of insurance to cover our risk. Because I have five children and my wife, Amy, does not work, I have a considerable amount of life insurance. Still, I probably don’t have too much insurance. Also, another principle for insurance is that we should only pay a premium to cover the risk of an event we hope does not occur. For example, I really don’t want to die right now. Nor do I want to be in a car accident.
Consequently, I have auto insurance, which introduces some additional factors to our discussion. By law, drivers must have liability insurance which pays the other person for property and injuries caused by the driver. We can choose, however, to have features such as collision insurance (covering repairs to our car for accidents we cause). When it comes to auto insurance, we also choose the level of a deductible we want. The higher the deductible (the amount you pay yourself before the insurance starts paying) the lower the premium. So, in theory, there should be no such thing as good or bad insurance. Insurance should match the risk, and is priced accordingly (but always beware of an unscrupulous salesperson). So, the principles to remember are that we should self-insure for anything we can, in other words, never buy too much insurance and insure only for risks that are unexpected and have severe consequences.
Eric B. Dent, a Lumberton resident, is a business professor at Fayetteville State University.