Arnold Kling  

Economists, Non-economists, and Insurance

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Co-blogger Bryan Caplan wonders why people make the insurance choices that they do.

I think that insurance is one of those topics on which economists and non-economists are out of synch. People buy extended warranties for appliances, but as commenter Jim Glass points out, they don't buy long-term care insurance. It's hard to write down a rational utility function that implies such behavior.

Among the reasons that people may be less rational about insurance than other matters:

1. Poor grasp of the concept of probability, and little or no understanding of expected value and variance.

2. No reinforcement from repeated events. If you keep buying stuff that you don't like, you start to notice sooner or later. If you buy insurance you don't need, or fail to buy insurance that you do need, you may not get enough negative reinforcement to change your behavior. Or, by the time you do get negative reinforcement, it's too late to change your behavior.

For Discussion. What other irrational biases affect people's decisions with respect to insurance?


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COMMENTS (9 to date)
John Brothers writes:

Speaking for myself, insurance is hard to budget for . I have enough money that I was able to afford term life and disability, but it wasn't easy. Disability is expensive! At the end of the day, I could see a lot of people who mentally block the idea that they will be maimed or disfigured sufficiently to need disability. In other words, the very concept is so awful that they can't summon the mental fortitude to plan and pay for it.

Dewey Munson writes:

Insurance

Take in Expensive money.
Pay back cheap money.

Most people ( I don't know most people and neither do you) don't understand minimum math which underlies the economy and therefore explains your "irrational behavior" .

Nimish Adhia writes:

I do not think that an understanding of the concepts of expected value and variance is necessary in order for people to make rational purchases of insurance, any more than it is necessary for them to understand first order conditions in order to make any other optimal choice.

That being said, it is possible that incomplete information about the actual probability of disasters and expected losses might cause people to not buy insurance.

Jon writes:

Extended warranties are small purchases; long term care insurance is a large complicated purchase. I buy neither--I don't know if the company I buy the policy will be around when I need it; I don't know the future inflation rate of long term care; I don't even know the terms of the product; I don't know whether the company can later offer the healthiest people a cheaper rate and jack up prices on others.

Finally I value time in a nursing home less a lot less than time spent out of one.

Randy writes:

The idea of insurance is that we must remain responsible, even after an unfortunate event. Its an interesting take on life, and a fairly recent one. Not much more than a century ago, those who fell victim to unfortunate events either died or became dependant on family. It seems to me that the idea that an individual "should" prepay for unfortunate events came into existance at about the same time as the paternal state. The idea being that the state "should" take care of the unfortunate, but the individual "should" avoid, if at all possible, becoming one of the unfortunate.

DK writes:

Another reason for extended warranties:
I would prefer to buy products for which the manufacturer offers extended warranties, b/c the manufacturer who sells extended warranties has a greater incentive to maximize the long-term quality of the product than a manufacturer who doesn't.

Of course, I would rather not buy the extended warranty and free-ride on the purchases of others.

Roger McKinney writes:

Could the difference between extended warranties and long-term care insurance have something to do with time preferences? Extended warranties cover a shorter time period into the future than does long-term care. It's not too different from preferring money today over money tomorrow. Maybe people discount the value of long-term care because the benefit would come too far in the future. Also, people tend to do straight line 4casting: I'm healthy now, so I 4cast that I'll always be healthy.

JP Bahantka writes:

I think people fail to buy insurance because of the transaction costs associated with doing so. A non-trivial amount of research is needed to find the right plan for an individual. Extended warranties, by contrast, have much lower transaction costs. It's easy to spend $10 a year to protect that new ipod when prompted to do so at the time of purchase.

Tim Worstall writes:

Aren’t we overcomplicating this a little? Extended warranties are hugely profitable for the sellers so there is also a large commission to the salesman selling them.
You’just bought an appliance and our salesman has a live bird standing right in front of him and for 3 minutes of blather he can earn $20 bucks or whatever.

Long term care insurace...you’ve got to go out prospecting for the customer, long and difficult sales cycle.

You might call it a supply side problem?

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