In an earlier chapter we discussed risk in the investing context. We called that speculative risk, where we take on a risk voluntarily with a view to receiving some expected reward.
But many risks we face are not voluntary, and they don’t offer a reward. We refer to these as Pure Risks.
According to Investopedia:
"Pure risk is a category of risk in which loss is the only possible outcome; there is no beneficial result. Pure risk is related to events that are beyond the risk-taker’s control and, therefore, a person cannot consciously take on pure risk."
A pure risk is one in which there’s a potential downside or loss, but there’s no beneficial upside: the only reward is that the bad outcome has not happened. One example of pure risk is the possibility of being injured or killed in a traffic accident.
Let’s compare this to an investment risk such as buying a stock. We buy stock because we want some potential gain or positive return. In contrast, in the traffic accident example we’re not consciously making a risk-return tradeoff. There’s no distinct upside to travelling on the roads. It’s simply something we do as part of life. We have to get to work, go shopping, and pick up our children after school. No one is standing and cheering at each destination, ready to give us some cash for completing each trip successfully.
Similarly, we don’t choose exposure to a potentially disabling disease with a view to gaining some upside. We simply accept that risk as an inevitable aspect of life. But we don’t have to allow pure risk realizations, such as death, disability, or personal liability, to destroy our household finances and devastate our families. Instead, we can use insurance to mitigate these risks.
Mitigation in this context doesn’t mean that we avoid facing the negative outcome. Rather, the mitigation is in the form of financial support that helps us and our family to weather the consequences of that bad outcome.
For example, disability insurance doesn’t stop you from becoming disabled, but it does replace your income while you’re disabled. Life insurance doesn’t stop you from dying due to a terminal illness, but it can provide a large sum of money to ensure your spouse and children are taken care of. Malpractice insurance doesn’t guarantee you won’t be sued for malpractice, but it does provide you with a legal defense team and money to compensate patients in the event a judgment goes against you.
We now have a preliminary answer to the question “what is insurance for?” It’s for mitigating pure risks for which we receive no reward.
To further refine our answer let’s ask the question: Do we need insurance to protect against all pure risks or just a subset of them?
To answer that consider your auto insurance and the choice you made regarding a deductible. The deductible is the amount of car damage you are responsible for before the insurer steps in to pay its share of repair bills. With a higher deductible you must cover more of the payments before the insurer’s obligation begins, while with a lower deductible you pay less before the insurer’s obligation begins. Since a lower deductible for you means more risk for the insurer, you must pay a higher annual premium than you would for a high deductible option.
If you believe insurance is for mitigating all pure risk then you would opt for the lowest possible deductible on your auto and home insurance. Similarly, when shopping for long-term disability insurance you would seek the shortest elimination period, allowing you to claim benefits soonest. You would also pay for short-term disability coverage to tide you over until long-term benefits begin and you may be inclined to accept the disability waiver of premium rider on your life insurance, which waives your life insurance premium payments in the event you become disabled. Each of these is an example of pushing more risk exposure to the insurer rather than retaining it yourself. And with each of these choices your premiums go up. The more risk you transfer to an insurance company the more you have to pay.
All of which begs the question: do you need to pay for all these protection extras?
Suppose you have a well-funded rainy-day fund in place, equivalent to six months of salary. You don’t really need the shortest elimination period on your disability insurance because you have enough cash to tide you over for six months. If you have a good disability insurance policy you don’t need to add disability waiver of premium to your life insurance. And you don’t need a low-deductible auto policy because you have plenty of cash on hand to cover a $1,000 bill for a fender bender. Covering such a bill yourself may seem painful in the near term, but it allows you to avoid hundreds of dollars in extra premiums, potentially over decades. And by not filing a claim from your insurer you can avoid your rates going up.
We’re ready to finalize our answer to the original question: what is insurance for? Insurance is for mitigating those pure risks that pose an existential danger to our household. That is, death, disability, liability, and property damages that would be devastating to our family finances. But insurance is not for the little things. We don’t need all the bells and whistles on our insurance policies, and we don’t need to push every exposure to the insurance company. Instead we can self-insure wherever possible, i.e., cover costs ourselves, and keep our insurance premiums as low as possible. Those savings can add up over decades to be quite substantial, and more than enough to compensate for the rarer occasions in which we pay out of pocket. Within the insurance industry this concept is known as the large-loss principle—insure against the big risks but not the small ones.