To self-insure or not

2025/01/02

To self-insure or not

This is a question that comes up repeatedly in real estate discussions. Does it make sense to pay for insurance for your property, for your HVAC unit, for home warranty. These are my recommendations, followed by my rationale.

Intro

An insurance policy is a contract in which you, the insured, pay a small amount, an insurance premium, on a regular basis (say yearly) to an insurer, in relation to a piece of property. In exchange, the insurer promises to pay you some amount of money If the property gets damaged.

This contract is a promise from the insurer to make you, the insured, financially whole if your property value is reduced because of some adverse event. In a way, it is a bet. You bet that something will eventually happen, and the insurer bets that something will not eventually happen.

All insurance policies come with a lengthy set of terms and conditions under which the insurer will honor their promise. As a potential insured, you should feel compelled to study this set of terms and conditions carefully, before entering an insurance policy contract.

General recommendation

Only insure when you can not afford not to.

Times when you may not be able to afford to:

In other words, whenever you know that you can afford to pay out of pocket to replace a damaged item - and there are no external forces that compel you to insure - you should “self-insure”, i.e. not pay for insurance but know that if the property is damaged you may need to pay out of pocket.

Why?

The business model of insurance relies on it being more likely that the money, on average, flows from yours to the insurer’s bank account. If it were not so, all insurance companies would eventually go bankrupt.

This means that over the lifetime of an insurance contract, you are likely to pay more to the insurer in insurance premiums than you are expected to get out of the insurer as a payout if your property is damaged. For this reason, it is likely cheaper for you to just wait for the damage to happen (or not), and simply pay out of pocket to repair the property if it is damaged.

Background

The decision to self-insure or not is clouded a bit by the fact that we usually do not know what the odds are that you actually sustain damage on the property. On the flip side, it is literally the insurer’s job to know these odds well, and to apply them to their benefit. This situation shows that there is a certain information asymmetry where the insurer usually knows better the odds at which to place a bet with you about something happening or not. And as can be shown from information theory, when multiple parties place the odds on a certain event, the party with a better estimate of the “true” odds has an upper hand.

As the insurer is expected to be better informed than you are - after all they have access to all sorts of statistics about the odds of any particular adverse event, the so-called actuarial tables. The insurers are more likely to set the odds correctly than you are, and if you bet against them you will lose on average.

This means that the best move is simply not to play. So long as you will not end up desolate if forced to pay for repairing your property, on average you will be better off self-insuring than paying for an insurance policy. This is, for example, the reason why I never pay for insurance policies for consumer electronics. If my iPad breaks, for example, it should be no special issue for me to pay $500 to $1,000 or so for a replacement. Your particular mileage may vary.

However, I can not be so relaxed about real property. I may not be ready to cash out $1,000,000 as a lump sum to replace a burnt-down house. I might therefore choose to insure my $1M property regardless of the fact that on average I will be worse off than not doing so.

Lender influence

Real property is typically bought using funds borrowed from one or more parties, the lenders.

This is done using a loan, or a mortgage, again a contract in which you, the borrower, promise to repay a lump sum of money given to you by the lender, over a number of payment installments, and with interest.

In such a transaction, the lender typically wants to take as little risk as possible. Specifically, the lenders like to remove risk to the capital they gave you by recording a lien on your property. This is a legal document which gives them the right to take the property from you according to a predefined legal process called foreclosure in the case you do not honor your part of the agreement to repay the loan (called a loan default).

Since the value of the property is more or less the recourse that the lender has in the case you “default” on the loan, the lender will require some assurance that the property still stands in the unlikely event that they need to take possession. The lender typically mitigates this risk by requiring you to insure the property to some minimum amount, typically the amount of the lender’s interest in the property. You are, of course, free to insure for more, but the lender is not interested in your share.

This means you may find yourself compelled to pay for insurance so that you can obtain the loan. If this is the case, and if you still want to purchase the property, you do not really have a choice.

Conclusion

With all the above said, the main questions you should ask yourself when looking to insure are as follows: