Risky business

6th May, 2006

The Undercover Economist – FT Magazine, 6 May

On a recent trip abroad, a reputable international car rental company tried to make me an offer I couldn’t refuse. For just 10 euros a day, I could protect myself from the frightening-sounding insurance deductible of 900 euros – a sum I risked being charged if anything happened to the car. I bravely turned them down.

This was a strikingly overpriced offering. For each day’s rental I was being asked to pay 10 euros to protect me from the risk of paying 900 euros. The mathematics are hardly difficult: the insurance is fair only if I crash into something every 90 days. If I believed that, I wouldn’t get behind the wheel at all.

There is plenty of overpriced insurance around, always bundled with some other product. A popular mobile phone retailer will insure your £50 phone for 92 pence a week – nearly £50 a year. The fair price of the insurance is probably closer to £5 a year than £50.

Economists are rarely tub-thumbing consumer rights activists. We tend to believe that people are smart enough to fend for themselves. But the commercial success of this kind of insurance is perplexing. The pricing is grotesquely inflated, but something more fundamental is also going on. A rational consumer should scarcely look at this kind of insurance, even at a fairer price.

Most people like insurance because they dislike risks. Economists used to think that this tendency was rational: your first million pounds is worth more to you than your second million pounds, so you should be reluctant to wager your first million on a coin toss. What you might win (your second million) is worth less to you than what you might lose (your first million).

You might protest that not all of us are millionaires. But the average worker, who earns roughly £25,000 a year for 40 years, makes £1m in their lifetime. Since they can borrow or save to spread the cost of windfalls and disasters across the years, the £1m is the relevant figure.

Few of us see risks that way. Matthew Rabin and Richard Thaler pointed out in 2001, in a paper that surprised even their fellow economists, that anyone who pays even slightly more than the fair premium to escape from a risk on a £50 phone or a 900 euro insurance deductible must be making a mistake. The stakes are too tiny: in the context of a £1m lifetime income, even 900 euros is a small enough risk to swallow.

We should turn down these offers of insurance and save the money in a contingency fund to pay for the occasional loss. The odds would be well in our favour and the petty uncertainty shouldn’t cause us a single sleepless night.

But I know only two other people who actually behave like this, and both of them are wealthy economists. Why will the practice never catch on? Economic psychologists have found 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 put through the washing machine – but it will be the loss of the phone that upsets me, and it is the risk of that upset that the phone insurers will try to emphasise.

The correct response is to insure yourself only against the big risks, such as your house burning down. As for the dent in the hire car, you will simply have to tell yourself that in the big scheme of things, it’s not that important. That is the closest that economics will ever come to Taoism.

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