Tuesday, March 15, 2011
Sophistry of Suckers: The Sillyness of Self Insurance
"Become Debt Free! Pay off your home, then you don't need the insurance! Once your home is paid off and kids are grown, you don't need more life insurance! Stop paying all that additional insurance, its a rip off! You can save on the cost of insurance and invest in the Stock Market. You will grow your paper assets to the point where you are self insured at my good growth mutual funds that have averaged 12%." ~ The Average Financial Adviser Expert
All of these concepts mentioned in this quote are given out by prominent Financial Advisers and TV Finance Gurus. They may not express these concepts verbatim or exactly in this fashion, but this is the underlying theme of this flawed philosophy. In my opinion, this type of thinking is like betting on horse racing without understanding the details of equines in the race. And, it is very risky. Let's look into this sophistry in more detail.
Self Insurance in Action with a major Catastrophe
Let's suppose you have a home that is worth $300,000. The mortgage is paid off, and you are DEBT FREE! You have accumulated in your 401k type plan $1,000,000. You take off your homeowner's insurance since you have enough assets to be "self-insured". A violent tornado hits your local town, and destroys your home, many local homes, buildings, and etc. Your home and all of its contents are totally destroyed. Nothing is left. What happens?
For starters you are out of a home. Your home needs to be rebuilt. How much will it cost to rebuild? The preliminary estimate to rebuild your home may cost $300,000. In this scenario, it may cost more than that! Why? If the tornado hits the local town, chances are that other homes are impacted. Since there will be a higher demand for labor and materials; the replacement cost of the home just went up! Ironically everyone is not a Contractor, so the value, demand, and the rate of this service has increased exponentially. Just think how that will impact your $1,000,000 if you are "self insured".
The contractors prices have risen, and same with the cost of materials. Materials that were destroyed from the Tornado, now must be transported into your town from another town. Prices of materials are now scarce, causing an increase in price.
Lets not forget the home had other items, food, appliances, personal belongings, etc. All these items need to be replaced. Since there are not an unlimited supply of refrigerators, TVs etc, that either requires a wait for your type of appliance, or deal with a sharp an increase in the price of the appliances.
While your home is being rebuilt, you need a place to stay. If there are hotel rooms available, they also are scarce, causing the ADR(average daily rate) and Occupancy Percentages for the local hotels to increase in price. Please do not forget, other people are seeking shelter while their home is being rebuilt; just like your family. This factor must be deducted from the $1,000,000 cash balance.
This may be a worst case example, but ask the folks during major storms if these things did not happen. Most homeowner policy holders quibble about the replacement cost, but never stop and analyze the complete economics of the situation in a major catastrophe.
This is why a comprehensive homeowner's policy is very important. Insurance provides the leverage to protect a valuable asset for little cost relative to the value of the investment or asset. In this horrible case, the most of the retirement cash monies would have been protected from the tornado. The majority the risk was transferred to the insurance company for a fraction of the net worth of the insured. The insured would keep the $1,000,000 cash in the 401k, plus the insurance company would cover the expenses related to the replacement cost of the home. The insured would also receive $300,000 from the insurance company to replace the home. The only cost incurred by the insured in this scenario if he had Homeowner's Insurance, would be payment for the deductible.
Your 401k plan being "Self Insured at Retirement"
Our previous example shows how having a proper Risk Management strategy can protect several assets in one catastrophic event, how about your hard earned cash retirement savings? Is it protected if you are "Self insured"? Let's take a scenario to show how being "self insured" at retirement is equally insane as the prior example.
You are 65, and your 20-30 year low cost, cheap term insurance policy has expired. You could choose to keep it in force, but the premiums are now annually approximately in the four figures. They also are projected to renew annually, so you opt out of the renewal. You are also told not to ever purchase permanent life insurance simply because it is a rip off. You have $1,000,000 saved in your 401k plan, no need for insurance, right? Your home is paid off, and according to your experts you are "self insured".
Here are some things to consider that are potential catastrophic "Risks":
1. Taxes- As the $1,000,000 is withdrawn, it will be taxed as earned income. Depending on how much is withdrawn annually, this money will be taxed on the current Earned income tax schedule. Of course, the home is paid off, so no interest deduction is used. In case of an early death by the 401k account owner, the IRS will want this money to counted towards the Estate Tax. If the money is still inside a 401k plan, the beneficiaries will need to ensure that that money is rolled into a qualified plan. If it is not, it will be taxed again.
2.Health Concerns-One of the fast growing segments of our population are people living to be age 100. But, there are obvious health concerns that are more common with the elderly population than the younger population. Let's hope that $1,000,000 can fill in the gap for those needs. If those needs are not met, then the need for Long Term Care, Pharmacy visits, Occupational Therapy, Physical Therapy, or other rising health care needs can not easily ignored if you are "self insured".
3.Day-to-Day Expenses-People worked their entire lives to enjoy retirement. What will be the quality of life? How long will that money last? Will you outlive your retirement savings? Cost of food, gas, other goods and services change with are Fed monetary policy and Government Spending. What will be the cost of gas? These things impact your wallet.
4.Safety of Principle-Based on the external factors of inflation, interest rates changes, stock market, bond market, and other external financial vicissitudes, will your hard earned retirement savings be surreptitiously eroded do to these factors? If so, how can you mitigate these risk?
5-Baby Boomers-This age segment of the represents approximately 28% of the total population. Like in our prior example of the home lost to the tornado and the scarcity of labor, materials, etc impacted the cost of rebuilding of the home, this variable is very similar. This age segment will make all the resources needed for this age segment more scarce, the net effect will be an increase on the price of services and goods specific to the needs of retirees and other age groups.
Based on these factors, and other that have been overlooked; having just cash in the bank at 65 may not be enough. All these concerns must be considered, simply scoffing or providing overly simplistic solutions to them is a sign of prodigality.
"But Robert you have scared me now!"
Taking control of your financial future is the first step. Becoming more familiar with the world of investing, insurance, etc is a way of mitigating these risks. Another way is transferring this possible risks to an insurance company, advisory firm, etc. These entities are experts in management of risks and assets.
The current popular belief that one product or one plan is the silver bullet for every situation. Unfortunately, this is not the case. The other myth, is that one product is cheaper or better than other products. This is also not the case. Each product exists to serve a purpose. If no one needed that product, it would not exits. It is your job to fit the correct product into your goals and plans.
In closing, simply being "Self-Insured" for retirement is equally as foolish as the person that removes his hazard insurance policy from his home. Here is a closing thought: In light of the recent events in Japan, what would happen if many of the major industries were "self insured"? People that lost 40-50% in the stock market are wishing that they where not self insured on the roller coaster ride over the last 3 years. Having a proper risk management strategy is equally important for your cash savings as for your other fixed assets.