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Insurance Should Stink

Most insurance products stink.

When you buy a term life insurance policy to protect your young family, there’s a very good chance that you’ll collect absolutely nothing in exchange for your premiums.

And when you buy homeowners insurance, there’s a good chance you’ll get back far less than what you spend on the policy.

And when you buy a fixed lifetime annuity, there’s a decent chance you’ll die well before reaching your life expectancy, thereby resulting in an atrocious return on investment for the money you spent on the premium.

And this stinkiness — the ability to “lose” each of these bets — is precisely what makes these products helpful.

Can’t-Lose Life Insurance

Imagine 1,000 thirty-year-old people buying 15-year term life insurance policies on the same day. Because most of these people will not die before age 45, most of these policies will pay out nothing at all. And this is what allows the insurance company to provide such a large benefit to the beneficiaries of the policyholders who do end up dying.

This concept is known as “risk pooling.” And it is what makes insurance worthwhile.

By way of comparison, imagine if our hypothetical 15-year term policy was instead rewritten so that the benefit amount was paid out to each policy holder a) upon death, or b) at the end of the 15-year term. In such a situation, there would be no risk pooling, because every policy is going to have to pay out. As a result, the benefit amount would obviously have to be dramatically reduced — so dramatically, in fact, that there would typically be no point in buying such a policy.

In other words, if an insurance product doesn’t offer the possibility of a very poor outcome, there’s going to be little or no risk pooling going on, and it will typically not be able to offer much bang for your buck in terms of protection against whatever it is the policy insures against.

When An Insurance Product Promises Everything…

Whenever you encounter an insurance product that promises to pay you money regardless of the situation, it’s time to be skeptical.

For example, equity indexed annuities (sometimes called fixed indexed annuities or hybrid annuities) are often sold on the premise that they:

  • Guarantee your capital, thereby protecting you against market declines, while
  • Allowing you to participate in market gains.

It sounds like a win/win. But if the insurance company is insuring you against loss, how can they afford to give you the positive returns that result when the market goes up? Where does the money come from?

As it turns out, the answer is that they don’t give you all of the returns from good years in the market. Typically, they leave out dividends, and they limit the return in other ways such as imposing an annual maximum. (In addition, they typically hit you with large surrender charges if you try to get out of the annuity within the first several years.)

Another insurance product that appears to offer a no-lose proposition is the variable annuity with a “guaranteed withdrawal benefit” rider. These products:

  • Guarantee a certain (non-inflation-adjusted) level of income for the rest of your life (regardless of how poorly the markets perform), and
  • Give you the chance to have that level of income increase if the underlying mutual funds in the annuity perform sufficiently well.

Again, it sounds great. But the reality might not be as good as the sales pitch. The problem is that:

  • The guaranteed level of income is significantly lower than what you can get from a simple fixed lifetime annuity, and
  • The annual costs charged on the investment are quite high — usually well over 2%, sometimes more than 3%.

As a result, it’s difficult for such products to outperform a simple “buy a fixed annuity and invest the difference” strategy. (Note: Vanguard’s GLWB product does have significantly lower costs than most such products, which makes it a much better deal.)

What’s the Catch?

If you can’t figure out the way in which an insurance product stinks — that is, you cannot figure out a single way in which purchasing the product could result in a bad outcome — that is not actually a good sign. In fact, it should be a red flag. More likely than not, it means your evaluation of the product is off-target in some way.

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  1. Paul Williams says

    Excellent analysis, Mike. You have honed in on the one thing everyone needs to understand about insurance. Most mistakes around insurance purchases center on this misunderstanding. People expect insurance to do things that it can’t actually do without making the insurance company go bankrupt, so they end up buying things that sound too good to be true (because they are) and paying massive hidden costs for years down the road.

  2. Great article. I think this misunderstanding is one of the first things that insurance salesmen hone in on when they try to sell you whole life insurance. They talk about “throwing money away” with term insurance, which preys on this anxiety that you aren’t getting a proper return. Insurance is not meant to get a return. It’s meant to protect you from devastating losses. If you want a return, you invest.

    Thanks for writing it so simply and clearly.

  3. Marc Sherman says

    Hi Mike,

    Good article. I would make one comment though regarding GMWB’s. While it is true that a fixed annuity and invest the rest strategy would produce better returns, we see a lot of clients who don’t have sufficient capital to make that strategy work. The GMWB is a hybrid solution that can help hedge some longevity risk for these clients, without forcing them to permanently surrender the majority of their capital, thereby allowing them some flexibility if their situation changes. Sometimes we use them in combination with an investment portfolio, sometimes in combination with fixed annuities, and sometimes all three together, depending on the clients’ situation and needs.

    Interestingly enough, a lot of these GMWB products that were being sold in Canada actually didn’t stink that badly as evidenced by the fact that ALL of the Canadian providers have either terminated or vastly scaled back their GMWB offerings!

    It is important to note, that when we are doing financial planning and looking at possibly including a GMWB, we ignore any potential investment return in our projections (after all, at 3% MER, returns will be pretty hampered). We look only at the guaranteed payout based on the amount invested and any annual “notional bonusing” offered by the GMWB contract.

  4. I once had an economics professor who, in response to low classroom attendance, said that undergraduates are the one class of consumers who insist on not getting what they pay for.

    To this I would add that insurance buyers should be the one class of consumers who hope they don’t get what they pay for.

    I will happily go on paying for our term life policies without cashing in.

  5. Niklas Smith says

    I would like to join the choir singing your praises – this is an excellent article that really gets to the heart of what insurance can (and can’t ) do.

    I work at a banking and insurance company in Sweden and am currently working on a project to write some educational material about personal finance for high school students. In researching existing material I’ve noticed that insurance is hardly covered at all so I feel it’s particularly important to include an explanation of what insurance is and why it can be worth having (despite that fact that you hope you’ll never have to use it). Would it be all right for me to translate part of your article and include it in the material I’m putting together with a credit to you?

    @Matt Becker: You have also hit the nail on the head: insurance isn’t a way to make money, it’s a way to avoid or reeduce the impact of disaster events.

  6. Niklas,

    Yes, that would be fine with me. Thank you for asking!

  7. Good tips on insurance. Sometimes insurance salespeople make insurance sound more complicated than it really needs to be, perhaps in order to confuse potential clients, but it’s nice when I get a chance to read something about insurance that is clear and that I can understand.

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