Having recently rented a rental vehicle, I had to decide whether I wanted to purchase the rental insurance. For only $32, I could have a $1,000,000 insurance policy (can I really do that much damage?). My choice was to not buy it, although I felt a great amount of fear and guilt in doing so. Rationally, I know that if I was in that great of a risk, then the cost of the insurance would be much greater. I also know that emotions play a great role in decision making and that companies use this to their advantage.
The role of probability also comes into play. In the last ten years, I have had zero accidents. That is probably in the normal range of accidents (I don’t feel that my driving skills warrant a job change to race car driver). So what is the probability that I get in an accident driving three hours? Probably not so high. In the long run, buying risk insurance is similar to gambling at the casinos. I might win a little, but in the long run, the casino and the insurance company has the better odds (or else they would not be able to operate).
Another interesting perspective comes from Daniel Kahneman, a Nobel Prize winner who describe risk aversion:
“If you think in terms of major losses, because losses loom much larger than gains you tend to be very risk-averse. When you think in terms of wealth, you tend to be much less risk-averse. I’ll give you an example: Suppose someone offered you a gamble on the toss of a coin. If you guess right, you win $15,000; if you guess wrong, you lose $10,000. Practically no one wants it. Then I ask people to think of their wealth, and now think of two states of the world. In one you own [your current assets] minus $10,000 and in the other you own [your current assets] plus $15,000. Which state of the world do you like better? Everybody likes the second one. So when you think in terms of wealth–the final state–you tend to be much closer to risk-neutral than when you think of gains and losses.”
Based on this explanation, the rental company is framing my decision on what I could lose in an accident.
Slate.com has an article on the topic of rental car insurance. Tim Hartford also writes about the field of economics relating to inside information.
The Aplia Econ Blog has an article on the inside information that insurance companies (or insurance consumers) may have when buying a policy.
I never thought about it that way… I will now next time I have to rent a car!
(from your stats course)