The big cost of avoiding risk
From BBC Online
Have you ever been made an offer you felt you couldn’t afford to refuse?
Most of us have had the experience of buying a mobile phone or hiring a car on holiday, to find that suddenly the friendly assistant is talking about frightening risks and offering to protect us from them.
Before we drive our hire cars onto the dangerous foreign streets, we are warned about the excess of 900 euros if something goes wrong.
For just 10 euros a day, we can make that worry vanish.
But before you sign up for your peace of mind, stop and think: economists think you might be making a classic error.
When should you pay over the odds for insurance?
If you pay 10 euros a day to protect yourself from a 900 euro excess, then that’s fair if you crash into something every 90 days.
Of course, if your driving is that bad or the roads are that dangerous, you should probably walk instead.
Even if you crash your car once a year or so, you would be paying four times more than was fair for your car hire insurance.
Whether you should do that or not depends on how frightened you are of risk.
Most of us worry too much about little risks like losing a cheap mobile phone.
One of the major phone companies will insure a cheap mobile phone for 92 pence a week, about £50 a year.
The phone itself will cost £50 to replace.
That is a typical price, but despite all the headlines about mobile phone theft, most phones live peaceful lives and die of old age.
The fair price for the insurance is probably closer to £5 a year.
What is more, most of the people who buy the phone insurance could afford to replace a £50 phone without having to starve.
We are buying protection from a risk that we can afford to take, and we are buying it at an incredibly high price.
You could take the money you would have spent on extra insurance for your washing machine, mobile phone and rental car and put it into a savings account.
For such small risks and such overpriced insurance, it is very likely that the savings account will contain enough money to pay for the occasional phone that falls down the lavatory.
In effect, you are insuring yourself, and at a fair price too.
It can make sense to pay for insurance, even overpriced insurance, to protect yourself from a big risk: your house burning down, or you becoming ill and unable to work for years.
For that kind of risk, there is no way your savings account will ever be big enough.
But that is what insurance is designed for: risks that you cannot afford to take, not risks that you can.
If you can bring yourself to keep cool about little risks, you should insure only the big risks, such as your house burning down.
(What counts as a big risk, of course, depends on how rich you are.)
As for the mobile phone in the lavatory, you will simply have to tell yourself that in the big scheme of things, it is not that important.
That is the closest that economics will ever come to Taoism.
The strange thing is, I only know two other people who actually behave like this.
Both of them are wealthy economists.
Why will the practice never catch on?
Economic psychologists have researched how we respond to risk, and discovered that we find it impossible to put our losses into context.
I should recognise that the value of my home fluctuates every hour by more than the value of the mobile phone I am so worried about losing.
It will not be the house price, but the theft of the phone that upsets me.
And it is the risk of being upset that mobile phone companies will remind me about next time I am in one of their shops.