What is self-insurance?
Self-insurance is a term used to describe when a person or company sets aside funds to meet contingency or emergency needs such as; injury, loss, or any other event such as, a person’s home being knocked down by an earthquake. If such an event happens, you spend the saved sum to help sort out the situation. But if the event doesn’t occur, you get to keep the money you may have otherwise paid in insurance premiums (the ongoing cost of having an insurance policy). Self-insurance works better in some situations than others and works better for some people than others.
Before we explore this further, let’s briefly talk through how insurance works.
Background: understanding how insurance works
To meet the costs of ‘unexpected’ events we only have two choices, to either:
- Accept the risk ourselves, and take appropriate steps to mitigate the risk – such as by setting aside funds as “self-insurance”, or
- Transfer the risk to an insurance company by taking out an insurance policy. In the simplest terms, this involves the insurance company pooling all the funds together from many policyholders and then paying for the losses that some policyholders may suffer.
There are a multitude of different types of insurance policies available, and virtually any individual or business can find an insurance company willing to insure them – for a price. The most common types of personal insurance policies are for life, income protection, health, and trauma; while the most common general insurance policies are for a home and vehicle. Most people in New Zealand have at least one of these types of insurance.
In theory, you can self-insure against any type of loss. However, most people choose to purchase insurance to protect against the impact of potentially large and infrequent losses. For instance, their house burning down. This is because it would be very difficult to set aside enough money to rebuild your home if it was destroyed, and the chances of a house burning down are usually quite low. This makes the cost of insuring a home against fire relatively low, so most people choose to have an insurance policy to protect against the potential loss.
When considering self-insurance, you’re weighing the certainty of spending money on insurance premiums against the possibility of incurring a loss that you won’t be able to rely on insurance to pay for.
For some people, providing their own insurance makes more sense than paying insurance premiums. The more predictable and smaller the loss is, the more likely it is that an individual or business will choose to self-insure. The logic is that as the insurance company aims to make a profit by charging premiums in excess of expected losses, a self-insured person should be able to save money
by simply setting aside the money that would have been paid as insurance premiums.
For example, someone who is fit and healthy, doesn’t drink alcohol or smoke, has a healthy family history, and who eats a healthy diet may choose to rely on the public health system instead of purchasing health insurance. Then, instead of paying an ongoing insurance premium for health insurance, they simply set aside the same funds for the eventuality that they may need treatment they can’t get fast enough or suitably enough through the public health system. They may even take this one step further by dedicating some of these funds to preventative steps such as, increased frequency of doctor and medical specialist visits – to further reduce the chances of needing significant medical treatment.
What are the risks of self-insurance?
An insurance policy is there to protect your finances, and helps you sleep at night through peace of mind. Insurance policies help protect people from eventualities such as, the risk of going bankrupt due to illness and not being able to work for a lengthy period (keep in mind that ACC will only pay out in the event of an accident, illnesses are your responsibility!), natural disaster, or the main family income earner not being able to work.
Especially for those who have a mortgage to repay and children who depend on them to keep food on the table, it’s vital to have most types of personal insurance (income protection, home, car, and life). As people age and repay the debt on their home and they no longer have people so dependent on them and the need for most types of insurance can be reduced.
2019 research by the Financial Services Council has shown that while New Zealanders are usually good at insuring their houses and cars, concerningly, we’re among the most underinsured people of any developed country. This study also found that most New Zealanders don’t:
Consider the risk of losing their income due to illness or serious injury.
Have savings or insurance in place to cover short-term loss of income, such as being off-work for three months.
Actively manage financial risk, such as significant life events which can impact daily life.
For the English guru’s
As some readers may have already identified, while self-insurance is a commonly used term, technically it’s incorrect. This is because with “self-insurance” there’s no insurance involved at all. Instead, it just represents someone accepting a risk and hopefully taking their own steps to protect against it.
The bottom line
Self-insurance is just one way to manage the possible events that life can and will throw our way. If you’d like to have a no-cost initial chat with one of our financial advisers about managing risks in your life – including by self-insurance – then please let us know.