By Ashley Bleckner, CFP®, MA
Let’s face it. Not everything in life is worth insuring. But, nearly everything we purchase these days has the option of insurance.
Traveling this summer? Better insure your flight through your airline. And how about your hotel reservation? Your travel agent may even offer trip insurance for the entire vacation.
Then there’s products. Have you ever been offered a 6-month warranty for $20 on an item priced at $80? I have. And, it happens in today’s market from electronics to appliances, and everything in between.
Is there a way to determine if it’s worth paying the extra money for insurances and warranties? Let’s try and look at it from the perspective of an economist.
Loss Aversion
The use of insurance to protect ourselves from loss has been around for centuries. The modern insurance industry (as we know it today) found its footing during the 1600’s.
Historically, insurance was used to protect against “large” losses. Only recently has insurance been used to protect against relatively small losses. Even more recently, products with built-in warranties will offer an “extended” warranty for these relatively small purchases.
At its core, buying insurance is giving up a small, specific payment today to ensure that a larger, uncertain payment is avoided in the future. Why do we do this? It is because of something called loss aversion.
The concept of loss aversion explains the phenomenon when the psychological impact from a loss is felt much greater than the psychological impact of a similar sized gain.
To insure or not to insure?
So how do you separate “fact” from “emotion” when evaluating the true value and need for these insurances? In general, there are only three (3) situations in which you should spend the extra money.
1. If Required – The first (and most obvious) is to buy insurance if there is an obligation. For example: if you want to drive a car in most states, then you must have insurance. The same is true for a home if you use a mortgage to finance the purchase.
2. High Probability of Use – Buy insurance when you know you will likely need it. That is, you should buy insurance when there is a high probability of the loss. For example, most of us do not need the extra insurance that is offered with our cell phones… unless you’re my 11-year old nephew who has a track record of breaking his cell phone. In that case, insurance is a great choice.
3. High Cost (Financially or Emotionally) – Lastly, buy insurance when the lost could be devastating financially or emotionally. The best example is health insurance. The medical bill that arises from an unforeseen health issue can skyrocket quickly without proper health insurance coverage – dipping into savings or other financial assets. However, if the financial loss of the commodity or good, say a leaf blower, doesn’t affect my financial well-being or lifestyle, I opt not to buy it.
While there is a good chance insurance isn’t a good idea for your next small purchase, sometimes insuring the little things can help us sleep easier at night. What is important is that we are informed buyers.
Source: Financial Media Exchange.