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Lottery - sure, that's a scam, barring the odd situation where a positive expected value is possible. Insurance on small events (i.e. the extended warranty fro
by cdjk 13y ago
Lottery - sure, that's a scam, barring the odd situation where a positive expected value is possible. Insurance on small events (i.e. the extended warranty from Best Buy) could be described as a scam, but homeowners insurance/car insurance isn't.
The whole reason insurance exists is because of differences in risk tolerance. What is a huge risk for me, such as a fire destroying my house, is a relatively small risk for an insurance company that is insuring against fires across the entire state. What I pay the insurance company for is to assume part of that risk.
Consider homeowners insurance, and more specifically fire insurance, in this admittedly contrived example. Suppose that in the next year there's a 1/1000 chance of a fire that will cause damage that will cost $100k to repair. That has an expected value of $100. Well, since $100k is a lot of money to me, I'd rather pay someone $200 than take a bet with an expected cost of $100, even though paying $200 has a negative expected value. That means I am risk averse for potential gains and losses on the order of $100k, and would rather take the more certain side of a bet, even if it means it has a lower expected value.
Take another example. Suppose I'm worried about losing or breaking my cell phone over the next year, and it would cost $500 to replace. AT&T charges $6.99/month for insurance on the phone. Over the course of a year that's about $84. And furthermore suppose there's a 1/20 chance that I'll lose/break/etc my phone during that year. Without insurance, the expected value of the loss is $25. Unlike the $100k example, $500 isn't that big a deal to me, so the insurance is a horrible deal for me, because I'm risk neutral for a $500 loss.
Of course, real life is more complicated. Homeowner's insurance protects against risks other than fire. Risks to the insurance company can be correlated - something on the order of the 1906 SF fire is a large risk, even to an insurance company, which is why there is reinsurance. There are deductibles that change the pricing. But still, as a simple example, that's how insurance works.
- gbog 13y agoYes, you describe exactly what is in Thinking Fast and Slow. So you are not rational, neither am I. But as you repeat the same patterns of risk aversion for all occurrences of a choice in your life, the sum is that you paid too much for insurance. A rational agent would pay 100$ plus the processing fee for the home insurance. It would not pay for "piece of mind", just as it would not pay for the "excitement" of a lottery ticket. We are not rational agent, but my point is that those who are closer to rational choice based on statistical truth are the one who win the game (in average).
- cdjk 13y agoUh, no. Risk aversion is rational. It seems like you're equating rationality with risk neutral preferences, which I, and a lot of other people disagree with. Besides, it's all about risk preference. As long as my preferences are consistent and transitive, I think it's safe to say they are rational. Take the fire insurance example. Suppose I have a job that pays $10k/year. I would gladly pay $200/year to avoid the possibility of a $100k loss. Those are my preferences, and as long as you can't a non-transitive loop, it's perfectly rational of me to have those preferences. In this case, I'd value the guaranteed loss of $100 to be a much better outcome than the risk of loss of $100k. In short, rational != risk neutral.
- gbog 13y agoExcept if your entire wealth is at stake, being risk adverse is not rational. That is the whole point of Thinking Fast and Slow. Proof is easy: I give you the choice to play on the flip of a coin, one side you win $1200 other side you loose $1000. You'll likely refuse because of fear of loss. Then consider I propose the bet 1000 times in a year, under different disguise so you don't recognize it. You lost 200 000! It is not rational to refuse a net positive bet it of irrational fear of loss. It is even more obvious for the lottery, because we would all agree that paying lottery ticket is irrational, right?