Self-Insure Explained: Definition, Benefits, and Drawbacks

What Is Self-Insure?

Self-insure is a risk management technique in which a company or individual sets aside a pool of money to be used to remedy an unexpected loss. Theoretically, one can self-insure against any type of damage such as from flood or fire, but most people choose to purchase insurance against potentially significant, infrequent losses.

Self-insurance might be more economical as a practical defense against predictable, smaller losses. Tenants might opt out of carrying renter’s insurance. But self-insurance comes with the risk of having insufficient funds available to deal with major incidents.

How Self-Insurance Works

Self-insuring against certain losses may be more economical than buying insurance from a third party. The more predictable and smaller the loss is, the more likely it is that an individual or firm will choose to self-insure. For example, some tenants prefer to self-insure rather than purchase renter's insurance to protect their assets in the rental.

The idea is that since the insurance company aims to make a profit by charging premiums in excess of expected losses, a self-insured person should be able to save money by simply setting aside the money that would have been paid out as insurance premiums. But it is critical to amass and put aside enough funds to cover you, your family, and your possessions if an accident or natural catastrophe occurs.

Real-Life Examples of Self-Insurance

For example, the owners of a building situated atop a hill adjacent to a floodplain may opt against paying costly annual premiums for flood insurance. Instead, they choose to set aside money for repairs to the building if in the relatively unlikely event floodwaters rose high enough to damage their building. If this occurred, the owners would be responsible to pay out-of-pocket for damages caused by a natural disaster, like a flood.

Similarly, a small business with two employees may opt against paying health insurance premiums for them. Instead it will self-insure them. This plan will generally take the form of a trust. Instead of an insurance company managing the investment and returns from premiums, the employer becomes responsible for the task.

Advantages and Disadvantages of Self-Insurance

When a person decides to self-insure, they run the risk of not having enough money to cover damages or medical care. Experts recommend always carrying a form of automobile insurance, even if you live in the two states that do not require it (Virginia and New Hampshire), insurance on your home, and medical insurance for you and your family.

It is possible to carry a bond instead of auto insurance in some states, but you are still financially responsible if you are in an accident, mainly if you are found at-fault. Paying for insurance is a safety net for you, your possessions, and your family. If you choose to self-insure, you may save money over the years. The downside? You must be willing to commit to saving a lot of money to protect yourself from emergencies—such as fire, floods, accidents, and even death.

In its original form, the Affordable Care Act (ACA) mandated penalties for individuals and small businesses that were not insured. According to some reports, this led to an increase in the number of self-insured businesses. Leading insurance companies have also begun offering alternate funding mechanisms for insurance. For example, one such plan calls for back-up insurance to stem losses from claims. Starting with the 2019 plan year, people without healthcare insurance do not have to pay a "shared responsibility payment".

The Bottom Line

Self-insurance is a method where individuals or companies set aside money to cover potential losses rather than purchase traditional insurance to brace financially for an emergency. Self-insuring can be financially beneficial when losses are predictable and minor, but it runs the risk of insufficient funds for significant losses.

Property owners with specific risks, like those in floodplains, may choose to self-insure, as well as businesses that are managing their employees' health insurance. It can save money over the years if you're not paying premiums, but having traditional insurance can be a lifesaver in the event of major losses.

The Affordable Care Act (ACA) initially mandated penalties for individuals and small businesses that didn't carry health insurance. Virginia and New Hampshire are the only two states that don't require auto insurance.