How to teach your kids about: The Insurance Trap
It might seem odd to talk to kids about insurance but there are a couple of good reasons to do this. Firstly, a key money lesson for kids to learn is about WANTS versus NEEDS and insurance is a great way to highlight the difference between these two. Secondly, insurance can help reinforce the amazing superpowers that come from saving money over time. Those that don’t learn to save will fall into the Insurance Trap which I’ll explain in more detail in this blog.
As insurance is a notoriously boring subject (I should know, I had to study it for many hours for my actuarial exams), for this blog I try to use a number of simple examples to make it easier for your kids to learn.
If you haven’t already, I would recommend you read my blog 'Rich Kids versus Wealthy Kids' before this one (not essential but helps with the bigger picture). Link to this blog here.
Very quick recap for you: What is insurance?
I appreciate most people know what insurance is but I thought I’d include it here for completeness. Insurance is when you pay an insurance company an amount of money (premium), either regularly or as a lump-sum, and they will pay you a much larger sum back if a certain event happens. There are a wide range of different types of insurance which cover different events happening.
Things people usually insure include:
Car insurance (pays out if your car gets damaged or damages others)
Life insurance (pays out if you die)
Medical insurance (pays out if you get ill)
Income protection insurance (pays out if you lose your job)
Home insurance (pays out if your house gets damaged)
Contents insurance (pays out if your contents gets damaged or stolen)
Travel insurance (pays out if something goes wrong on your holiday)
The amount you have to pay for insurance depends on the likelihood of the event happening and the amount the insurance company will have to pay out in that event. The more likely an event is to happen, the higher the amount you have to pay for insurance in insurance premiums (e.g. younger drivers are more likely to crash a car than more experienced drivers so their insurance will be higher). The more the insurance company might pay out will also lead to a higher cost of insurance (e.g. insuring a new BMW will cost more than a new KAI).
Some insurances are optional (mobile phone cover) whereas others are compulsory (third party fire and theft for your car).
When talking to my kids, I used a made up example. I simply said, if you lived in a wooden house then you could pay an insurance company an amount of money and they would re-build the house if it got burnt down.
The link between insurance and wealth
Insurance is expected to make you poorer, not wealthier. This is not to say you shouldn't buy insurance, it's just a statement of fact.
The insurance companies look at the odds of people suffering a bad event and how much they might have to pay out. They work out what would be a fair cost to cover that cost and then add on a profit (which is completely fine as they need to run a business).
Let's expand the simple example I used with my kids above. Imagine you live in a wooden house and it takes 5 trees to rebuild if it should get caught in a forest fire.
The chances of this happening are slim. It might happen once in every 5 years.
What would be a fair price for this event? In 4 years you don’t expect anything to happen so you get no money from the insurance company and then in one year you expect to get paid 5 trees so you can re-build your house.
So you expect to get 5 trees every 5 years. You just don’t know which year you’ll get your 5 trees (i.e. you don’t know when there will be a fire). Expecting to get 5 trees every 5 years is equivalent to getting 1 tree every year on average. So 1 tree per year is the fair cost of the insurance.
However, an insurance company isn’t going to be around for long if they receive 5 trees and give away 5 trees, every 5 years. They need to make a profit and also need to have money in case more than one forest fire occurs every 5 years.
So instead of charging you 1 tree a year, they charge you 2 trees a year. So over 5 years you give away 10 trees (2 trees x 5 years) and only expect to get 5 back! This is not a great deal for you.
This is an important point. Given the above we shouldn’t WANT to have insurance as it’s expected to make us poorer over time.
The Goldfish versus the Elephants - How insurance companies work
I’m not sure how many of you find the technical stuff interesting but I’m a geek and love this stuff. So I thought I’d just expand a little more on how insurance companies work.
Let’s assume there are two groups of people taking out insurance for the loss of a £500 mobile phone. There are the Goldfish. They are always losing their phones. Then there are the Elephants. They always seem to know where their phone is. Despite never losing their phones before, the Elephants fear they might in the future and don’t want to pay £500 for a new phone.
Let’s say the cost of the insurance is £50 per year.
Now, each year a Goldfish loses their phone! The insurance company pays them £500 to get a new phone. Where does the insurance company get the money to pay the Goldfish this £500 for a new phone? From the Elephants who all pay £50 but never require the insurance to pay them anything.
Therefore, if you are an Elephant and look after your things then insurance is even worse for you as you are paying money to cover the losses from those annoying Goldfish (we all know one!).
Insurance companies do try to ask questions to see if you are more like a Goldfish or an Elephant and make some adjustments to how much they charge.
WANTS VERSUS NEEDS
Teaching our kids about the difference between wants and needs is a vital part of money education. Many people spend a lot of money on the things they think they NEED, but it is actually something they just WANT. Insurance is a good place to help your kids understand the difference between WANTS and NEEDS.
As mentioned above, there are some insurances which are compulsory so it doesn’t matter if you want it or not, you need to have it. This includes third party fire and theft for your car in the UK. Most other insurances are optional so you can choose if you WANT / NEED it or not.
Let’s start with the WANTS
There are very few people who should WANT to buy insurance from a financial point of view given it’s a bad deal I set out above with the trees.
The reason people WANT to have insurance is that bad events are stressful and we don’t want to think about money in that stressful situation. We’d rather pay a bit more now to avoid worrying about money in the future.
For example, if the wooden house did get burnt down, you just want the 5 trees now to build a new one ASAP so you can get on with your life.
We all hate the prospect of losing a lot of money. We are willing to pay a bit more to avoid that scenario and hence we WANT insurance. This is the concept of “loss aversion,” the theory that people feel the impact of losses more than they do gains of the same size.
Our desire to WANT insurance allows insurance companies to charge us more and make a nice profit. You probably know that electrical stores make a large amount of their profits from selling people ‘extended warranty’ on the products they buy as people fear something going wrong with their new TV or fridge.
Also, most people are terrible when it comes to predicting the chances of events happening. People tend to think events happen more often than they actually do. This is another reason people WANT insurance (it’s also the reason people play the lottery).
Now let’s talk about NEEDS
This is another really important lesson as it highlights why some people keep getting wealthier whilst others never seem to have money despite earning ‘good’ money.
If you don’t have any savings then you are much more likely to NEED insurance. Let’s go back to the wooden house example. If you don’t have 5 trees available to build a new house then you NEED to buy insurance (otherwise you might not have a home if there is a fire).
If you have lots of trees then you don’t NEED this insurance as you can use those trees to build a new house. You might still WANT the insurance for the reasons mentioned above.
If you don’t NEED insurance and you don’t feel you WANT the insurance then you are expected to be better off financially, i.e. become wealthier.
So the more savings you have, the wealthier you are expected to become!
The Insurance Trap
The Insurance Trap is combining some of the above points together.
When people start earning ‘good’ money they expect to feel more financially secure and happy. However, in many cases that doesn’t happen. Instead of saving some of their money, they end up spending more (Keeping up with the Jones’). This means they have:
More things to insure which costs them more money each year
As they don't have savings they have a greater NEED to insure these things.
Essentially, they earn more money but end up spending their additional money paying higher insurance premiums on the new things they buy. This is called the Insurance Trap. They are trapping themselves from building up their savings due to an increase in insurance premiums from their spending habits.
Conversely, those that save some of their money will have less stuff to insure and don’t NEED to insure everything as they can rely on their savings (trees) to cover the loses of some events. This means they will keep more of their money and get wealthier over time.
Help your kids learn the basic idea of insurance - you don’t need to go into the detail of all the different types, just pick an example or two.
Some insurances do certainly deserve consideration. Help your kids understand the difference between WANTING and NEEDING to have insurance.
Importantly, make them aware that by saving some money it means they can become wealthier over time by avoiding the Insurance Trap (i.e. they won't need more insurance each year).
Lastly, remember that whilst it is great for you to talk to your kids about this topic and other money topics, the most important thing you can do to help your kids grow up to be financially healthy and wealthy is to give them pocket money and then encourage them 'not to spend it ALL'. This will help them form a life-changing money habit. To find out more please read this blog here