As you increase your net worth by paying off high-interest debt, building an emergency savings fund, and investing in stock market index funds via a 401(k) plan, individual retirement arrangement (IRA), taxable brokerage account, and, if applicable, 457 plan and/or health savings account (HSA), you achieve financial freedom and work toward financial independence (FI), which is the ability to live off your portfolio returns without earned income. During this journey, certain types of insurance become unnecessary, while others become critical.
Here I will briefly discuss two types of insurance: automobile (car) insurance and health insurance.
As you accumulate assets, some insurance becomes unnecessary and of poor value—namely, insurance that covers expenses that are assuredly small, in relation to your emergency fund. However, insurance that covers potentially unlimited downside becomes vital, because all your assets could be stripped away without it. (Exceptions exist, such as your retirement accounts and primary residence, but this depends on state law and the circumstances—for instance, in some states your retirement accounts can be seized in a court judgment if you were driving drunk or criminally negligent, but not for other types of at-fault accidents.)
Auto insurance is divided into coverage that pays for damage to your motor vehicle (i.e., collision and comprehensive coverages) and coverage that pays for injuries and damage to others’ motor vehicles and property (i.e., bodily injury liability and property damage liability).
Many people take a loan out to purchase a new car, with little or no savings. They are neither financially independent nor financially free; consequently they need collision, comprehensive, and “gap” coverage. Collision covers damage to your car when you collide with an object, be it another car, a boulder, et cetera (although if another driver was at fault and has coverage, their insurance should pay for your car’s damage). Comprehensive covers damage such as a tree falling on your parked car, hail, or theft. These types of insurance both have deductibles, typically $500, and in a given incident they only pay the amount of damages that exceeds the deductible amount (with some exceptions, such as in Florida, by state law, the deductible for comprehensive is waived for replacing a broken windshield).
Both collision and comprehensive coverages only pay up to the fair market value of your car. This means these insurances do not cover potentially unlimited downside, but rather downside that is capped and predetermined. You can look up the present value of your car using Kelley Blue Book, providing the make, model, year, condition, and mileage. This value, minus your deductible, is approximately the maximum your auto insurance will ever pay out under these aspects of your policy. Consequently, people with plenty of savings typically do not need collision and comprehensive coverage, because they can just pay for auto repairs or a replacement car out-of-pocket.
We often heard about homeowners being “underwater” on their mortgage after the housing crisis, meaning they owed more toward their mortgages than the fair-market value of their homes, despite having paid a down payment and months or years of mortgage payments. This same phenomenon happens on a massive scale with buyers of new cars, because they lose quite a bit of value quickly, causing the amount owed to exceed the car’s value. Thus, people buy “gap” insurance to pay the difference between fair-market value and what they owe, in case their car is totaled. Obviously, having three extra types of insurance (collision, comprehensive, and gap) is costly and perpetuates poverty.
Liability auto insurance, on the other hand, covers potentially unlimited expenses. If you are at-fault in an accident, others’ injuries could cost hundreds of thousands or even millions of dollars. However, you can’t bleed a rock, as the saying goes; people without assets can always declare bankruptcy without losing much besides their credit score, which may already have been damaged to begin with. Although this is socially irresponsible, the more pressing and probable financial need for a low-net-worth individual is repairing or replacing their car, which is why collision, comprehensive, and gap coverage are often prioritized over high bodily injury and property damage liability limits.
Therefore, people approaching FI generally don’t need collision, comprehensive, or gap coverage, but probably should have mid-six-figures of bodily injury protection and $1 million or more in an umbrella policy to cover other scenarios that could destroy their progress toward FI.
A hidden benefit of auto insurance is that your insurer has lawyers and procedures to minimize what they pay out to injured parties, such as pretending the victims of an accident weren’t really hurt that bad, or making lowball offers for immediate payout that the victims will be tempted to take. If you were to self-insure, you would have to hire your own lawyer at great expense to you. However, if your liability limits are low, your insurance company might just pay the limits and walk away, leaving you on the hook to hire a lawyer to settle with the victims for their medical bills, lost wages, pain and suffering, et cetera, which will come directly out of your accumulated savings and investments because you didn’t have adequate insurance.
Health insurance pays for your personal medical bills—a potentially unlimited expense. Like with auto insurance, low-net-worth individuals can declare bankruptcy to escape medical debts, but someone working toward FI cannot and would not want to do this.
Like with auto insurance, that has the hidden benefit of legal counsel, health insurance has the hidden benefit of negotiated rates. For example, when my grandmother was suffering a brain tumor (may she rest in peace), the hospital transported her by helicopter to another hospital 90 miles away, which was first billed at $47,000, and then reduced to a negotiated rate of $5,300 when Medicare and her insurer paid. An uninsured individual would be billed at $47,000, and could probably negotiate this down quite a bit, but not necessarily all the way to $5,300.
Many types of medical providers expect to work with insured patients, and may be surprised or not even accept patients who do not have insurance. In the United States, people buy or receive health insurance through various “pools,” the largest of which is employer-sponsored insurance, but with the Health Insurance Marketplace, Medicare (for seniors), the Department of Veterans Affairs, and several others providing insurance for millions of people.
In addition to the benefit of negotiated rates, health insurance being tied to your employer offers benefits of economies of scale (they can get a lower rate due to having many employees) and lower taxation. For example, if you pay a premium through your paycheck, this deduction is exempt from payroll and income taxes. Of course, there are also many downsides to the U.S. system.
A great option for those on the path toward FI is a “high deductible” health plan (HDHP). It offers downside that is capped and predetermined—your annual deductible limit, which might be as high as approximately $15,000. Beyond this deductible, it insures against potentially unlimited downside. People on the road to FI need health insurance, for the benefit of negotiated rates and to protect their unsheltered assets from 100% erosion. But, they don’t need a plan that pays for every minor expense. HDHPs also open the opportunity to contribute to an HSA, which is extremely tax-advantaged and can be invested in an index fund of the whole stock market, just like a 401(k), IRA, or taxable brokerage account. Although you may have better insurance via your employer, if an HDHP is a reasonable option, it makes sense for financially free individuals, but not for those who could not pay $15,000 or $30,000 toward their medical bills (don’t forget that your ailment could span two calendar years!).
Overall, auto and health insurance are necessary for both low- and high-net-worth individuals, but different types and levels of coverage are appropriate for each. Low-net-worth individuals always have the “you can’t bleed a rock” factor, so they might insure against small expenses they could not pay out-of-pocket, while leaving the bankruptcy option open for large expenses. Those on the path toward FI have the savings to cover small and moderate expenses, making some types of insurance unnecessary, while the concern of protecting their assets looms large.