Why Self-Insurance is a Myth

Oh, Dave Ramsey, you’re at it again.

In a recent response to a reader’s question, Dave took a little bit of information from the reader and made some sweeping recommendations on actions that she could take.

Unfortunately, those recommended actions could cost the reader and her family a lot of money!  (wait ‘til you see the numbers below!)

And it all boils down to this concept of being “self-insured” that Dave refers to.

Let’s take a look:

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Posted Jun. 14, 2016 at 11:53 AM

Dear Dave,

My husband and I are retired, we both receive nice pensions, and we owe $46,000 on our home.  This is our only debt. I’m 65, he is 82, and we have more than $800,000 in variable annuities, along with substantial cash in savings. We also have $200,000 combined in life insurance coverage. If we cancel these two policies we can pay down an extra $10,000 a year on the house. Should we cancel the life insurance policies?

— Anna

Dear Anna,

At 82 and 65, you probably won’t be able to get any more insurance at a decent price. If you get rid of it, you’re going to be without it. The good news is that you have enough money through your pensions, investments, and savings to be what is known as “self-insured.”  If I’m in your situation, I’d drop the life insurance policies and pay off the house as quickly as possible. Make sure you keep a good health insurance policy in place, because a hospital stay can eat your savings alive. I hope you have long-term care insurance, too. Good question, Anna. You guys have done a great job with your money.

—Dave

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Now, I agree with Dave that this reader has done a good job up to this point.  Anyone who has diligently saved and positioned themselves to be liquid with a strong income has done something right!

But before we go making recommendations, Dave, let’s make sure we understand the definition of insurance and this concept of being “self-insured”.

Insurance: an arrangement by which a company provides a guarantee of compensation/indemnification for specific loss (in this case death) in return for the payment of a premium.  Insurance is designed to indemnify a loss.  (Indemnify – make whole)

Insurance, by its very nature, transfers the risk of loss to someone else.

If you decide not to transfer that risk to someone else, then you carry that risk yourself.

Being “Self-insured” then, by definition, is taking that risk of loss on yourself.  You decide to not transfer it to someone else.  You agree to absorb the loss from your own assets.  You are, by definition, “not insured”.

Self-insured = Not insured

Let’s use this example to help illustrate this point.

Now, the person on the left is insured.  They have decided to transfer the risk of loss of the house to another company.  That way, if something happens to the house, it will be replaced by the insurance company. Preventing person A from having to spend all their assets to replace the house.

The person on the right, according to Dave Ramsey, can consider themselves “self-insured”.  Would Dave recommend they cancel their homeowner’s insurance?  If we follow his logic, this person can replace the house with their own cash because they have “enough money” to do so.  So let’s say they decide not to transfer that risk and to “self-insure.”

Well, 5 years later, both houses burn down.

Let’s take a look at the situation again.

You can see, by now, that person B thought they were “self-insured”.  What really occurred is that they were not insured.  They had no one to transfer that risk to, and they, themselves, absorbed the loss entirely when it occurred.

“The only things certain in life are death & taxes.” -Benjamin Franklin

Now, in the case of life insurance, the loss is not the loss caused by a house burning down, or by a car accident, or by dropping your cell phone in the pool.

The loss is the loss of a life.  The loss of income.  The loss caused by death.

And in the case of life insurance, it is the one type of insurance where you can be certain that inevitable will happen at some point, and trigger a death benefit payout.

So, back to the reader.

In this case, it seems as if the reader is focused on the “price” of the policies.  She is looking for confirmation to cancel their life insurance.  And Dave Ramsey gave it to her.

The problem is, both the reader and Dave Ramsey are potentially making a BIG mistake.  They have completely overlooked the cost of this quick decision based on minimal information.

Price vs Cost

What’s the difference?

Well, the reader is describing that if she cancels the policies that promise $200,000 of death benefit on their lives (I have to assume $100,000 on each?), they will be able to redirect $10,000 of cash flow a year towards something else.

Their focus is on the “price” of the policy at $10,000 a year.

What they are completely overlooking is the “cost” of making that decision.

By canceling the policies, they would immediately lose $200,000 of death benefit, $200,000 of potential long-term care benefit (if there are LTC riders on the policies), and $200,000 of legacy to their children (if they have kids and that is a goal of theirs).

[If the policies are permanent policies, with guarantees, and level premiums and other benefits, canceling the policies will be the equivalent of losing an asset and a direct reduction in net worth.]

That $10,000 “price” could result in $200,000 or more of cost and loss of net worth!

When one of them dies, there will most likely be a loss of income of some sort.

• If they have insurance, that death benefit will be paid and help offset that cost.
• If they are self-insured, they need to use their own money to replace the income.

When one of them dies, they may want to leave a legacy behind for their spouse, or any children or grandchildren they may have.

• If they have insurance, that $200,000 death benefit will be paid, tax-free to their beneficiaries. (Keep in mind: assuming a 25% tax rate, a $200k tax-free DB is the pre-tax equivalent of $266k in assets!)
• If they are self-insured, no death benefit will be paid, resulting in $200,000 less being left behind to their family or loved ones.

(Also, there may be a Long Term Care rider on the life insurance policies that can help offset any long term care costs that Dave refers to.  It is just interesting that he recommends to cancel the life insurance prior to identifying more details about the policies themselves.)

A price vs cost difference of this size ($10,000 price vs $200,000 loss of net worth with all the items mentioned above) needs to be looked at and evaluated a little more closely than with an 8 sentence email response!

What needs to be understood clearly as Dave makes this quick, short-sighted, recommendation is that a decision to cancel life insurance is a decision to take that risk of loss back on your shoulders.

It is difficult to make any type of recommendation for Anna at this point (and it may be considered borderline reckless), because we are missing a lot of details that would help analyze Anna’s situation, and allow us to truly determine if it makes sense to follow Dave’s advice.

Anna, at the very least, if you understand now that “self-insured” means “not-insured”, you may look a little more critically at how much Dave’s advice might cost you!

Want to be sure you won’t make this mistake for yourself?

That’s what we are here for.  Read our Blog.  Watch our webinars.  Schedule a talk with one of our strategists.  Paradigm Life is here to make sure you make educated decisions.  It’s your hard earned money.  Learn how to best manage it!