Insurance vs Self-Insurance: When Coverage Isn’t Rational

Insurance is economically valuable when it protects against low-probability, high-severity losses that could derail long-term financial stability. For small, predictable, or easily absorbed expenses, however, insurance premiums often exceed expected payouts over time, making self-insurance the more efficient choice. The key decision is not whether insurance has negative expected value (it usually does), but whether a potential loss would meaningfully disrupt your finances. As assets and liquidity grow, it often makes sense to retain more first-party risk while preserving coverage for catastrophic property losses and large third-party liabilities.

• Insurance is risk management, not wealth-building: Premiums are designed to exceed claims to cover costs and solvency; paying them makes sense mainly to avoid financially devastating outcomes.
• Self-insurance works best for manageable losses: If a worst-case loss can be covered from liquid savings without debt or long-term disruption, retaining the risk is often more efficient.
• Deductibles are a form of self-insurance: Higher deductibles, older-car collision exclusions, and high-deductible health plans shift routine losses back to you while preserving catastrophic protection.
• Hybrid strategies reduce cost without excess risk: Combining self-insurance for routine expenses with umbrella or stop-loss coverage protects against rare, extreme events.
• Correlated risks still justify insurance: Disasters like hurricanes or wildfires create simultaneous, inflated losses, making catastrophic coverage rational even for high-net-worth households.

The conventional wisdom around insurance suggests that more coverage always equals better protection. This is not universally true. In certain situations, purchasing insurance for small, predictable losses is economically inefficient, as premiums are structured to exceed expected payouts over time.

In these cases, insurance functions as a cost of risk transfer rather than a wealth-building tool. Understanding when self-insurance is appropriate requires grasping the economics of risk transfer and honestly assessing your ability to absorb losses without threatening long-term financial stability.

The Expected Value Problem

Most insurance policies are designed as negative expected value transactions for the insured pool as a whole. On average, insurers must collect more in premiums than they pay out in claims in order to cover administrative costs, regulatory capital requirements, claims handling, commissions, and long-term solvency. This is not a flaw in the system, it is the economic reality of insurance.

Consider a simplified example. If an insurer expects to pay approximately $800 per year in claims for a given risk group, premiums might average around $1,000. The difference covers operating expenses and reserves, with a relatively small portion allocated to profit. Over time, across the entire pool of policyholders, expected premiums exceed expected claims, even though individual outcomes vary widely.

This creates a natural question: if insurance has negative expected value on average, why purchase it? The answer lies in risk management rather than return optimization. Policyholders accept a known, limited cost in premiums to avoid the possibility of a low-probability but financially devastating loss. For large, unpredictable risks, such as the total loss of a home, the trade-off is rational. For smaller, predictable expenses that can be easily absorbed, insurance is often less economically efficient.

What Self-Insurance Actually Means

Self-insurance means intentionally retaining financial responsibility for certain potential losses instead of transferring that risk to an insurance company. Rather than paying premiums and filing claims, you deliberately set aside resources to cover specific expenses if they occur.

This is different from simply going uninsured. A self-insured individual has evaluated their risk exposure and made a conscious decision to retain manageable risks, often by maintaining dedicated savings or sufficient liquid assets. Someone who is uninsured, by contrast, has not deliberately planned how losses would be absorbed, increasing vulnerability to unexpected financial strain from even moderate events.

Businesses have practiced self-insurance for decades, especially large organizations with predictable loss patterns. Many employers self-insure health benefits, paying claims directly instead of purchasing fully insured plans. To limit exposure to extreme losses, they typically purchase stop-loss insurance, which caps liability above a defined threshold. This structure blends the cost efficiency of self-insurance with protection against catastrophic claims.

Individuals also engage in informal self-insurance for smaller, predictable costs. Paying out-of-pocket for minor vehicle damage or routine dental care instead of submitting claims reflects a choice to retain low-severity expenses. The real decision point is determining which risks are small enough to absorb personally and which are large enough to justify formal insurance coverage.

The Break-Even Calculation

The rational decision point between insurance and self-insurance depends on three factors: the probability of loss, the magnitude of that loss, and your financial capacity to absorb it.

• Low probability, low severity: These losses are generally poor candidates for insurance. Extended warranties on consumer electronics often cost around 10–20% of the product’s purchase price, with expected failure rates already reflected in pricing. From an expected-value perspective, most consumers will lose money on these warranties over time, though risk aversion or liquidity constraints can justify them in some cases.
• Low probability, high severity: This is insurance’s core use case. Events such as a house fire, major liability lawsuits, or permanent disability are unlikely but financially devastating. Paying premiums with a negative expected value is a rational tradeoff for protection against catastrophic loss.
• High probability, low severity: Predictable, routine expenses are inefficient to insure. When claims are expected with near certainty, premiums must cover both claims and administrative costs. These products often function as prepayment or discount arrangements rather than true insurance.

The fourth category, high probability, high severity, rarely appears in private insurance markets. Losses that are both likely and expensive are generally uninsurable without government mandates or subsidies, as adverse selection would make coverage unsustainable.

When Self-Insurance Makes Sense

You should consider self-insuring when the maximum potential loss would not materially impact your financial stability. This threshold varies by individual based on asset levels, income stability, liquidity, and risk tolerance.

A commonly used rule of thumb is to self-insure losses that can be covered from liquid assets without taking on debt. Some planners use an illustrative guideline of around 5% of liquid net worth, but this is not a formal standard. For someone with $100,000 in accessible savings, absorbing a $5,000 loss may be reasonable, while larger losses may warrant insurance.

This helps explain why higher-net-worth individuals often choose higher deductibles or decline coverage for low-severity risks. With sufficient assets, they can absorb losses that would be financially damaging for others. In recent years, some homeowners in high-risk areas of states like Florida and California have faced significant premium increases in certain renewal cycles, particularly for hurricane- or wildfire-exposed properties, leading some to rely more on higher deductibles or selective self-insurance.

Common situations where self-insurance often makes financial sense include:

• High-deductible health insurance paired with HSAs: For generally healthy individuals with adequate cash reserves, high-deductible health plans can significantly reduce premiums. Health Savings Accounts provide tax advantages while building reserves for future healthcare costs. For 2025, HSA contribution limits are $4,300 for individuals and $8,550 for families, with contributions tax-deductible and qualified medical withdrawals tax-free.
• Declining collision coverage on older vehicles: If a car is worth $5,000 and collision coverage costs $800 annually with a $500 deductible, you are paying a large percentage of the vehicle’s value each year. Over time, premiums can exceed the car’s market value, making self-insuring collision coverage sensible while maintaining liability coverage.
• Increasing property insurance deductibles: Raising a homeowners deductible can reduce premiums. If claims are infrequent, cumulative premium savings may exceed the higher deductible over time, effectively shifting smaller losses back to the homeowner.
• Small business property in low-risk areas: Businesses with diversified assets and sufficient cash flow may self-insure certain property risks at individual locations, often while retaining catastrophic or umbrella coverage for severe losses.

The Hidden Costs of Self-Insurance

Self-insurance isn’t free, it carries opportunity costs and behavioral burdens that aren’t always obvious. Money set aside as reserves for potential losses typically must remain liquid and low-risk, which limits return potential. If you maintain $10,000 in a savings account or money market fund earning around 4% annually, you may forego higher long-term returns available from equities. While stock market returns are volatile and not guaranteed, this difference in expected returns represents a real opportunity cost over time.

Self-insurance also requires consistent financial discipline. You must deliberately maintain reserves rather than reallocating those funds elsewhere. When losses don’t occur for extended periods, some individuals may be tempted to repurpose self-insurance funds for spending or other investments. Unlike insurance premiums, which are mandatory and recurring, self-funded reserves depend entirely on personal commitment and structure.

Administrative responsibility increases as well. Traditional insurance transfers much of the claims process, loss evaluation, payment coordination, and dispute handling, to the insurer. When self-insuring, you manage loss recovery directly. This is manageable for routine expenses but can become burdensome for situations involving multiple parties, legal considerations, or significant repairs.

The Stop-Loss Hybrid Approach

Many individuals and businesses adopt hybrid strategies that combine self-insurance for routine losses with catastrophic coverage for worst-case scenarios. This approach seeks to capture the cost efficiency of retaining manageable risks while maintaining a safety net against financial ruin.

Employer-sponsored health plans frequently use this model. The company self-insures employee claims up to a defined per-person or per-claim limit, then purchases stop-loss insurance that covers claims exceeding that threshold. This structure can reduce costs associated with routine medical claims while protecting against rare, high-cost medical events such as complex cancer treatments or neonatal intensive care.

Individuals can apply similar principles. Choosing higher deductibles on property and auto policies effectively self-insures the first portion of any loss. Pairing this with umbrella liability coverage extends protection beyond standard home and auto liability limits, guarding against large legal claims that exceed those underlying policies. Together, this combination preserves catastrophic protection while avoiding insurance for losses that are financially manageable.

Risk Pooling and Correlated Risk

One critical limitation of self-insurance involves correlated risk, situations where many people suffer losses simultaneously. This is why homeowners in disaster-prone regions face particular challenges with self-insurance.

Insurance works by pooling largely uncorrelated risks. Most policyholders do not file claims at the same time, allowing insurers to pay losses from collected premiums and reserves. Natural disasters strain this model by creating concentrated losses from hurricanes, wildfires, or earthquakes that affect many policyholders at once. Insurers manage this risk through reinsurance, geographic diversification, and capital reserves, but the cost of protection rises significantly in high-risk areas.

When you self-insure, you bear this correlated risk alone. If a hurricane damages a coastal home, the loss often occurs during periods when repair costs rise due to labor shortages and increased demand. Self-insurance reserves may need to cover both the physical damage and inflated recovery costs, potentially diverting resources from other financial goals. This is why catastrophic property insurance, despite high premiums, often remains rational even for wealthy individuals.

Making the Self-Insurance Decision

Evaluate self-insurance opportunities systematically rather than reactively. Begin by reviewing your existing insurance coverage and identifying policies that protect against losses you could reasonably afford to absorb. For each policy, note the annual premium and consider what would happen if you eliminated that coverage and consistently saved or invested the premium amount instead.

Ask yourself these questions for each policy:

• If I experienced the largest loss this policy would realistically cover after deductibles and exclusions, could I pay it from savings without borrowing or derailing long-term financial goals?

• How much do I pay annually in premiums, and how does that compare to the types of claims I’m likely to file?

• Does this coverage protect against truly catastrophic loss, or mainly predictable, manageable expenses?

• What is my realistic likelihood of filing a claim, and what would the financial impact likely be?

Be honest about your risk tolerance. Some people value the certainty of insurance even when self-insurance may be cheaper over time. The psychological benefit of insurance, reduced anxiety and protection from worst-case outcomes, has real value, even though it doesn’t appear in mathematical return calculations. If maintaining coverage meaningfully improves your financial confidence and decision-making, that alone can justify the cost.

The Bottom Line

Insurance serves a vital purpose: protecting against losses you cannot afford to absorb yourself. When coverage extends beyond that core function to insure routine, predictable, or financially manageable losses, particularly when those losses could be paid from existing savings, it often shifts from efficient risk management to a form of long-term wealth transfer to the insurer.

The key is identifying your personal threshold where insurance remains economically justified. Below that threshold, self-insurance tends to be more cost-effective in expected value terms, even though occasional losses will occur. Above it, insurance provides essential protection against financially disruptive or ruinous events, making the negative expected value of premiums a reasonable tradeoff for stability and security.

As wealth increases, this threshold generally rises. Greater assets improve your ability to absorb first-party losses, reducing the need for insurance on smaller risks. However, this principle applies mainly to losses you directly incur; protection against large third-party liabilities often remains essential regardless of net worth. Understanding this distinction allows you to optimize coverage, preserving insurance for genuine catastrophes while avoiding unnecessary premiums for risks you can responsibly retain.