The dangers of self-insurance: why you should think carefully before choosing to not purchase insurance cover

In the last few weeks I have received a few emails from investment advisors who avoid selling income protection to their clients. They argue that their client is better off using the premium they would pay for insurance as an additional investment contribution. If they are disabled and thus unable to work, they would cash out some of their investment portfolio to meet their loss of income.

What these advisors are prescribing is that their client self-insure their risk of being temporarily disabled. This means that they choose not to buy income protection to cover the risk that they are temporarily disabled. The theory is that if you have sufficient savings in your investment portfolio, you can choose not to transfer this risk to the insurer. Since the premium you pay to an insurer contains loadings for the insurer’s expenses and profits, as well as their margins for risk, you expect to make a saving by not purchasing insurance.

While the advisors are arguing against purchasing income protection, you can extend that same argument around self insurance to not purchase car insurance, household contents insurance, or even medical aid.

However, you should be aware that choosing to self-insure introduces some serious risks.

The main risks of following this approach are as follows:

The accumulated value of your investments are insufficient to meet your loss if the risk event occurs

This is the main risk of being self-insured. Consider if you chose not to purchase income protection. There is the very real risk that if you are disabled and unable to work within an early period of your investment, your accumulated savings are not sufficient to equal the payout you would have received had you purchased an income protection policy.

For the most part, temporary income protection policies have a 24 month benefit term (the policy will pay for periods where you are unable to work for up to 24 months). So you are at risk while the accumulated value of your investment is less than the income you would earn over two years.

Consider a 30 year old individual who earns R50000 a month. An income protection policy that pays for temporary disabilities for periods of up to 24 months will cost him approximately R550 per month. The maximum amount this policy could pay out is R50000 x 24 = R1.2 million. If the client decided instead to not purchase income protection, but instead decided to invest the R550 per month in a unit trust that earned 9% pa, it would reach R1.2 million when the client reached age 62. So until the client reached 62, his savings would not equal the amount that would be paid on an income protection policy for a two year claim for the first 32 years of investing.

The investment return I have assumed is on the low side, however:

  • I have not assumed any salary inflation at all (very unrealistic)
  • I have not factored in that income protection premiums are tax deductible
  • You should assume a prudent investment return, because this investment risk remains with the client

So, the first risk identified remains for anyone who chooses not to purchase temporary income protection if they do not have an investment portfolio equal to two years’ worth of earnings. While the accumulated value of their investment portfolio is less than two year’s worth of salary, they are at risk of having insufficient savings to meet the cost of having a two year claim.

The example above is specifically for temporary income protection, but you can picture this risk for other types of policies as follows:

  • If you choose not to purchase car insurance, this risk remains for as long as the accumulated value of your investments is less than what you would be paid out on a car insurance policy if your car is stolen or written off
  • If you choose not to purchase medical aid, this risk remains for as long as the accumulated value of your investments is less than the maximum payout for any medical condition, which is potentially millions of rand

Even if you do have savings greater than the cost of the risk event, self-insurance still puts your retirement planning at risk.

Again, let’s look at an example in the income protection space. Assume that a 40 year old now has an investment portfolio equal to exactly two years of earnings. So the above risk is no longer present. If they were to be unable to work for two years, they can use their savings to meet their expenses for two years.

However, they have extinguished all their hard earned retirement savings. They have been disciplined enough to save a huge amount for retirement which is now reset to zero. At age 40, this represents a massive setback to their retirement planning and they will need to make tough life changes in order to rectify the situation.

Investing is not a realistic alternative to purchasing income protection, car insurance, medical aid or any other type of insurance. The way I see it, an insurance policy actually works hand in hand with good investment planning to protect your retirement savings. The impact of an event covered by an insurance policy might not impact on you today, but it will have big impact on your retirement planning in the future. Not purchasing insurance only defers your problems to a later date.

The practical problems with self-insurance

Even if you are comfortable with the above two risks, there are considerable practical problems with self-insuring. These are:

  • Money in a retirement annuity cannot be touched until you retire
  • Money in a pension / provident fund cannot be touched unless you leave your job
  • There are costs associated with realising unit trusts
  • If your investment is in illiquid instruments (think property or private equity), it is incredibly difficult to realise these investments at short notice, and there is a strong likelihood you will need to sell them at considerable discount in order get any cash for them.

Beyond that, we need to remember that investments are volatile. Consider if you need to realise part of your investment when the markets are down. You will be forced to realise your investments when their value is reduced. This risk is commonly forgotten, but it is a bigger problem than most people perceive. When you need cash on short notice, you lose your ability to time the market and are forced to realise your investments at whatever their value is at that stage.

Consistency of approach across your risk portfolio

This is less of a risk but more a philosophical issue. If an advisor advises that their client should follow this approach and not purchase one type of insurance policy, they should also advise them to not purchase most other forms of insurance. If the client’s savings are going to insulate them from one particular risk, then it should also be there to meet costs associated with other risk events. I have my doubts that this is what actually happens in reality, and advisors are thus in danger of giving advice that is inconsistent across all the major risks that an individual has.

Conclusion

You should think long and hard before deciding to self-insure, because you are choosing to retain some quite serious risks

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Why the JSE game does more harm than good to young investors

Like a lot of South African high school students, my first meaningful exposure to investing in shares was when my classmates and I entered the JSE game in grade 11. Like most boys we didn’t take it seriously enough and I’m pretty sure we just stopped playing at some stage!

In the last few years I have started building my own personal portfolio. It was quite an interesting learning experience, as I chose to do my fellowship exam in the investment field. I have tried, as far as possible, to apply sound investment techniques that I learnt from my studies to my own portfolio.

I recently did start thinking about the JSE game that we played back in high school, and I thought about the lessons that it teaches our youngsters. While I applaud the game for its intentions, I feel quite strongly that the structure of the game hinders more than it helps.

A quick summary of the game

There are three versions of the game.

  • Income based

Players are required to protect their assets against inflation and maximise the income earned from that portfolio. Players are not rewarded for asset appreciation over and above inflation.

  • Equity growth

Players are required to maximise their return on a portfolio. They may not use derivatives and can only buy shares in the FTSE/JSE top 40

  • Speculator

Players are required to maximise their return on a portfolio. They may invest in any share and they may use derivatives

The problems with this structure

I actually quite like the structure of the income based version of the game. However, this is only really applicable to very old investors. Furthermore, most students tend to play the speculator version of the game. There are a number of problems with the above structure, most of which come straight out of a text book.

  • There is no allowance for risk in the evaluation of your performance. If players are not penalised for taking extra risk in the assets they choose to invest in, then rational players will simply choose the riskiest shares with the highest expected returns. Investing without factoring in risk is not investing at all.
  • The time horizon is too short. Given that the game takes place over one school year, the actual investment time frame is less than a year. You do not invest for months; an investment is for years.
  • Derivatives can complicate the issue, and they are tools for speculating, not investing. Most adults who use derivatives don’t fully understand them. I think it is a bit optimistic to expect newcomer to the JSE to understand how to use them properly.

My main concern is the first bullet point. A group who do their homework and construct a solid, well balanced and well researched portfolio will more than likely be beaten by a team that just picks randomly risky shares (If enough teams construct very high risk, high expected return portfolios). If enough teams choose very risky portfolios, a lot of them will perform poorly, but some will just get lucky and beat the well constructed portfolios. Is this fair?

The short time frame also introduces a large degree of luck. The shorter the time period, the more random the contest becomes. Investing should encourage you to evaluate the long term prospects of a share. However, if you’re only playing the game for a few months, it is not in your best interest to do this. Effectively, the time horizon effectively forces players to become traders.

What should be done?

I am well aware that the structure of the game is the simplest possible, and any changes will make the game more difficult to understand or run. However, I believe that every South African should start building a portfolio as soon as they start working and they should continue to build it until their retirement and beyond. The JSE game could really help to encourage youngsters to do this.

In order to make this happen, the game needs to:

  • Make some allowance for the riskiness of shares chosen. There are smarter people than myself who should be more than capable of developing a simple and effective risk adjustment to the returns on the portfolio. This in itself will get youngsters to start thinking about risk.
  • Take place over a longer period. It could start in grade 11 and continue for 5 years when the student finishes university. This encourages students to invest and not speculate
  • Ban derivatives! They are poorly understood and complicate the game. If there are institutions that don’t use derivatives because they are too complicated, then the same should apply to beginners.