Insurance premium can be defined as a certain loss that you accept in exchange for the reduction of small probability of a large loss. Inherently, it has negative expected value.
Insurance triggers pervasive social norms. Most of us buy insurance without considering an alternative strategy. Similarly, when buying a car, we purchase also extended warranty. Vividness of costly repair, coupled with social norm favouring insurance and warranties leads many consumers to make risk averse choices.
To test this, Slovic (1982) conducted an experiment. He tested if a sure loss as an insurance premium makes the loss more attractive, even when objective amount of loss is the same. Researcher asked the participants to choose between:
- Insurance Premium (or a Certain Loss)
- Risky option that had a small probability of significant loss
Study participants were more likely to choose the risk-free option when it was called an Insurance Premium than when it was called a Certain Loss.
People are more likely to accept a certain loss if they view it as insurance rather than a sure monetary loss. Generally speaking, consumers would be better off if they said no to all “extended warranties”, put money saved in the bank and use it to pay for necessary repairs. Across life span, we would save much more money.
Bazerman, M.H. and Moore, D.A., 1994. Judgment in managerial decision making (p. 226). New York: Wiley.