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Friday, May 9, 2008


Inspired by Michael James' posting on insurance today, I'll add my 2 cents on the subject.

Let's go back to basics. Just what is insurance? In a nutshell, insurance is simply hedging the future. It's about being able to obtain something with better certainty down the road. Since time is always moving forward, the notion of the future permeates our entire existence. As such, insurance is everywhere. In its simplest form, anything with a future promise attached to it is insurance. Reach into your wallet and pull out some paper money. What is that? It's insurance. It is a promise to provide a good or service in the future. Without it, you will have a harder time obtaining that good or service. It is a form of a promise, or a contract if you will. This contract we call money mitigates your trading risk in not being able to obtain a good or service.

So what exactly is risk? Risk is about the future not unfolding the way you need it to occur. It exists because the future is not predictable with absolute certainty. What is one of the least predictable things that has the biggest impact on mankind? The weather. Can you buy weather insurance? Of course you can. The agricultural industry relies upon it. Farmers buy crop insurance all the time. Your house is likely insured against catastrophic weather damage. You have heard of the futures or commodities market, right? That's a bunch of people trading a form of agricultural insurance. By insuring themselves against supply abundance and demand collapse, farmers can plan and successfully run a business. The futures contract removes his risk of not getting enough money for his crop. Removing risk is a valuable service, and thus insurance costs money, often big money. Insurers are usually quite sneaky about hiding the real cost of it from you. Also, most insurance has a date or other condition on which it ends, and thus usually becomes less valuable as the end condition approaches in the absence of the insured risk.

You can find insurance embedded in almost everything. Did you buy something with a warranty attached to it? Insurance. Did you take out a loan with a fixed interest rate? Insurance. Sports gambling can be seen as happiness insurance if you bet against your team. Many credit cards have insurance products built into them as well. Service insurance, unless it involves money refund and a impartial ombudsman, can be somewhat useless. If somebody screws up performing a service (eg. a haircut) are you likely to give them another chance even if it is free? If they have somebody else who is competent to fix the problem, then perhaps.

How do you put a value on insurance? Well, if you're an insurer, it is all about calculating the risk, and putting a value on the potential payout. Then they'll add a profit margin on top of that, the amount of which depends on supply and demand curves for the insurance product, basic econ101 stuff. The risk calculation can be extremely complex, involving intricate mathematical models with closely guarded markov chains. The potential payout is also subject to complex calculations potentially obfuscated with all kinds of exclusion clauses.

What do you, as a consumer, need to know about valuing insurance? Well, if the law requires insurance, such as car insurance, then you have no choice. Shop around, and potentially raise the deductible to the maximum amount you can afford should the worst happen. But in general, don't buy insurance if you can afford to deal with the bad future event actually happening. Extended warranties, especially on electronics, are seldom worth buying. If they cover accidental damage and you have young children, then perhaps you do want to consider them since the odds of payout will be high. If you feel that your circumstances are different from most consumers such that the odds of payout (check exclusions!!!) is quite high in your favour, then perhaps you should buy the insurance. Also, look at insuring yourself. Be it for a mortgage (see my previous post) or for insuring electronics, put the extra payments into a savings account and use it for repairs or replacement. Also by insuring yourself, you don't put a deadline on when your insurance would expire. Your money remains with you and is not lost.

2 comments: said...

for a lot of consumer products I find the best "insurance" is to purchase from a store like Costco with their no questions asked return policy, no point in paying for insurance when they offer it to you for free

Jim Somerville said...

Good point. Warranties typically consist of two components, namely the store takeback part which is often quite time limited, and the manufacturers part, which is often longer eg. a year. The manufacturers part of the warranty is usually quite burdensome to deal with as compared to store takeback. If you get a low price and the store takeback portion of the warranty is extremely generous, then you have a winner. As you point out, Costco has an extremely generous takeback policy.