Wednesday, June 6, 2007

Covering your Assets -or- Do you Need that Warranty?

Be Prepared
-Boy Scout Motto

Unless you've got a way to look into the future*, you have to deal with the unexpected road bumps that life throws your way. How do you keep this from throwing your life into a tailspin? It take a combination of prevention and reaction known in the business world as Risk Management.

Think in terms of a car. Cars break down all the time, so how do you cope with it? You can try to Prevent the breakdown by doing regular maintenance, you can get a warranty to cover those charges, or you can accept your fate and be ready to pay for the repairs.

Prevention sounds like the best option, and it usually is. The drawbacks are that 1) it's not always possible to anticipate everything that can go wrong, and 2) there's some point where the cost of prevention is greater than the expected loss. Foe example, how many homes have sprinkler systems in place? Most people agree that some prevention is necessary in any Risk Management plan.

Sharing the risk through insurance or warranties is another option. You pay someone else to take the risk for you. The drawback to this is that the amount you pay is usually more than the expected loss.

For those of you who are playing at home, the expected value of a loss is the probability it will happen (0 = impossible, 1 = sure thing, .5 = 50/50 chance, etc.) and the amount of the loss. So if you have a 2% chance of totalling your $10,000 car this year, your expected loss will be .02 * $10000 = $200. Anything more than this would be profit for the insurer. Of course, you have to factor in all types of accidents, their probabilities, the values of different repairs based on the accident type and the vehicle involved. If that sounds complicated, it is! The good news is that the insurer has done the work for us. They are out to make a profit, so any amount they charge you is going to be higher than the expected value.

Why would you buy it, then? The only good reason to purchase insurance, which includes warranties, is that you just can't afford to take the loss at all. Life insurance can fit into this category, if there isn't enough in savings and others rely on you income. Catastrophic health insurance, Home owner's insurance, and liability insurance are other potential examples where the risks can't just be accepted. Warranties on your MP3 player or mobile phone aren't. Automobile insurance usually has a combination of the two types of coverages. With any of these, it's important to understand what the plan covers.

The final option is to accept the risk as a part of life. I mentioned that warranties on consumer goods aren't a good idea, this is because if you loose your player, you can simply buy a new one or go without until you can. Raising the deductible on your insurance means you are accepting $X more of the risk involved. Somebody with enough money can afford to become "self-insured" from a life insurance standpoint. This is the best option (combined with prevention) in cases where the loss can be financially managed without coverage.

*How about some lottery numbers, or even the next Superbowl winner?

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