On a recent trip abroad, a reputable international car rental company tried to make me an offer I couldn't refuse. As is standard practice in Europe, basic insurance was included in the price, but for just $10 a day, I could protect myself from the frightening-sounding insurance deductible of $900—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 to protect me from the risk of paying $900. 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 cell phone retailer will insure your $90 phone for $1.70 a week—nearly $90 a year. The fair price of the insurance is probably closer to $9 a year than $90. Economists are rarely tub-thumping 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 dollars is worth more to you than your second million dollars, 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).
That explains why people would want insurance for million-dollar risks, but not $90 risks. It is not at all clear that the $90 that you might lose if your phone is stolen is so much more significant than the $90 you might "win" by not paying for a year's insurance.
You might protest that not all of us are millionaires. But a million dollars is just $25,000 a year for 40 years—less than most of us make in a lifetime. And since we can borrow or save to spread the cost of windfalls and disasters across the years, the million dollars is the relevant figure. Compared to a million dollars, a coin toss for $90 is trivial.
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 $90 phone or a $900 insurance deductible must be making a mistake. The stakes are too tiny: In the context of a $1 million lifetime income, even $900 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 favor 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 determined that we find it impossible to put our losses into context. I should recognize that the value of my home fluctuates every hour by more than the value of the cell 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 emphasize.
The correct response is to insure yourself only against the big risks, such as your house burning down. As for the dent in the rental car, you will simply have to tell yourself that in the scheme of things, it's not that important. That is the closest that economics will ever come to Taoism.
The Undercover Economist appears on Saturdays in the Financial Times Magazine.