Jeremy Stein - Journal

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Insurance and Warranties

I didn’t buy an extended warranty for my camera. I don’t have collision insurance. I opted out of the warranty for the lawn mower. I would never, never consider buying pet insurance.

Why?

Because insurance and warranties are sold at a profit; that’s why.

No, no, I’m not against companies making a profit. It’s just that their profitability helps me to make some calculations about the value of the insurance or warranty.

Let’s suppose I wanted to buy a toaster. The salesman… er, salesperson spends 15 minutes convincing me that if I want a toaster that will last, I should buy the Dualit Vario Toaster which is on sale for $300. It’s a great bargain, so I take it. The salesperson then spends another 15 minutes explaining all the things that are likely to break on this toaster. None of them can be fixed; I’d have to replace the toaster. But not to despair.. they offer a comprehensive one-year warranty for only $60!

What should I do?

Well, let’s see… If the toaster needs to be replaced within the next year, I’ll save $240 by purchasing the warranty. But, if it doesn’t break, I’d be wasting $60. I need to determine how likely it is to break. From the warranty sales pitch, it sounds like there’s at least a 50% chance the toaster will break. Putting down $60 on a 50% chance for $300 is decent bet. Maybe I should do it…

Not so fast. What does the manufacturer think is the likelihood that the toaster will break? For every 100 warranties sold, the company gets $6000. They expect to make a profit, so they must have good reason to believe that fewer than $6000-worth of toasters (20) will break. Of course, I didn’t mention that they padded the price to account for overhead, a sales comission and a ridiculous profit margin. Let’s suppose that they expect to pay $3000 in toaster replacements (10 toasters). The company believes that out of every 100 toasters, 10 will break in the first year. How can I use that information to my advantage?

For me, the consumer, I’m betting on just one toaster. It might be worth $60 to have the peace of mind knowing that I won’t have have to spend another $300 on my bread-toasting needs in the next year. But the company has many, many bets. They’ve diversified their risk among thousands of gullible chumps risk-averse warranty-purchasing toaster-owners. They will make a profit. It is more likely that the entire executive staff of that company will be eaten by alligators in Idaho than it is that all the toasters will break. This is the same reason that casinos are so profitable. The odds in all the games are weighted slightly against the gambler. 49% of the gamblers win money; 51% lose money. The end result is that the casino always wins. With warranty companies, the odds are even more in their favor.

Well, that doesn’t really help me. It seems the only way I could win for certain is to buy 1000 toasters. Than I could be pretty sure that 10 of them would break, and I’d be ahead by replacing those ($3000) rather than buying warranties ($6000) for all of them. But I don’t need 1000 toasters!

Ah, but I do need one refrigerator. And one stove. And one dishwasher, washer, dryer, furnace, water heater, camera, camcorder, computer, etc. And I’m going to need those things for many years to come. I can diversify by not buying insurance or warranties for anything that I can afford to fix or replace, from now until I die. If every month, I set aside the money I would have spent on insurance and warranties, it will be more than enough to pay for the repairs and replacements that would have been covered under those financial safeguards. It’s possible that my account may go a little negative at first. That’s like when the first gambler in the casino wins. But no fear; the casino always wins in the end.

By diversifying across products and over time, I can make the same bet that insurance and warranty companies make. And I will win.

July 8, 2005 2 Comments.

2 Comments

  1. Shannon replied:

    Your overconfidence is your undoing!

    July 8th, 2005 at 9:07 pm. Permalink.

  2. CJ replied:

    Forget the extended warranties…you just need the right life insurance.

    July 10th, 2005 at 3:28 pm. Permalink.

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