At first blush, this seems to be a good use of insurance. For a nominal cost, insurance helps us spread the risk of a catastrophe. Consider auto insurance. There is a very small chance I will total my car in the next year. It’s hard to predict whether that will happen, but one thing is sure, it is all or nothing. Either I will or I won’t.
However, predicting the number out of a large group of people who will total their cars becomes much easier. While we don’t know who will total their cars, we do know about what percentage of people will. This predictability allows an insurance company to determine the average number of claims and set an annual premium that covers the anticipated claims and generates the company a profit.
Insuring market crashes works much differently. Michael Kitces, in his Nerd’s Eye View blog post of November 20, explains, “The problem with trying to insure against a market catastrophe is that the risks don’t ‘average out’ over time, instead, they clump together.” In other words, the insurance company has either no claims or 100% of their policy holders having claims.
Why? When insuring against a stock market decline, there are absolutely no claims when markets trend upward. However, when markets head down, every policyholder potentially has a claim. Kitces notes that usually “companies are very cautious not to back risks that could result in a mass number of claims all at once. This is why most insurance policies have exclusions for terrorist attacks and war.”
To help insure against this concentrated risk, the companies uses several methods to design these policies. One is to collect a fee for the guarantee that funds a reserve to offset potential losses. Kitces says this fee is so “tiny” that it “just doesn’t cut it.” He gives an example of a company with $300 billion of guaranteed annuities where the market declines 25%, exposing the company to a $75 billion loss. A guarantee fee of 0.5% is only $1.5 billion, not enough to even begin to cover the losses.
Another way the companies mitigate their loss is that, unlike auto insurance, these policies do not pay immediate benefits. If the market drops by 50%, you don’t get a check for your original investment plus a fair return for the time they had your money. What you get is a promise to pay you a lifetime stream of income, usually at some date in the future. If you had a portfolio of mutual funds holding thousands of companies and purchased a “guaranteed living benefit,” you actually transfer the diversified risk to one insurance company that has actually concentrated, rather than spread, the risk.
Does this mean you should avoid variable annuities? No, as not all of them concentrate their risk. Most allow you to invest in a broad range of securities and spread your risk. Consider avoiding annuities that have a “guaranteed living benefit” and fees of over 1%.
Kitces cites two other options for investors. One is to keep your portfolio invested in mutual funds that hold a broad selection of securities and simply lower your risk by owning less equity and equity-like investments and more bonds. A second is to spend less, keeping your withdrawal rate under 3%. Practicing both of these strategies is a way of providing your own insurance against market crashes.