Insurance as Risk Management
The expected-value framework for insurance decisions — what to insure vs self-insure
You're offered an extended warranty on a $1,200 laptop for $199. The warranty covers defects for three years beyond the manufacturer's one-year coverage. Should you buy it?
Most people answer with their gut: 'It's expensive, I'll skip it' or 'I always break things, I'll get it.' Neither answer is correct. The correct answer requires exactly two numbers: the probability of a qualifying failure, and the cost of that failure without insurance.
If the probability of a $1,200 failure in years 2-4 is less than 16.6% ($199/$1,200), the warranty is a bad bet. Consumer electronics failure rates in years 2-4 are typically 3-8%.
The warranty costs $199 but its expected value to you is $36-$96. You should decline. This is the framework for every insurance decision you will ever make.
Every insurance product is a bet. The insurance company is betting that your premiums will exceed your claims.
That is the opening. Finishing a lesson is where it stops being interesting and starts being useful: the full lesson runs to 6 sections and ends with 5 practice questions. A free account is what opens the rest, and the other 255 lessons in the Academy with it. No card.
What this lesson covers
- 1Insurance as expected-value math
- 2The insurance decision formula
- 3The insurance matrix: insure vs self-insure
- 4The five policies worth having
- 5Insurance expected value calculator
- 6Deductibles: buying back expected value