The Real Purpose of Auto Insurance

The guiding idea behind our buying insurance is to transfer risks that we at least are not comfortable with or can’t bear on our own to an insurance company who has the capacity to bear these risks.

An example of this is our insuring our home against loss, where losing our home would not normally be something that we would able to endure without serious financial implications.

The Real Purpose of Auto InsurancePerhaps we’ve been paying on it for years or decades and we will end up losing everything we put into it if it burns down and we aren’t insured, or more typically, we have borrowed for it and owe a great sum of money that we are still obligated to repay and now have to find another place to live.

All insurance coverage needs to be approached this way, as we do pay a price for it and we need to make sure that the benefits that we receive outweigh the costs overall.

This cost isn’t just the premium, it is the excess cost over what it would cost us to bear the risk ourselves. In terms of pure value, insurance is not a good deal at all, as the real premium here is the risk premium that we pay for the insurance company to bear the risk instead of our having to do it.

If we had the complete ability to bear the risk of a loss, for instance with the loss of an appliance of very modest cost, like a toaster for instance, it wouldn’t be worth it to purchase the coverage since we’ll be paying out considerably more than we may expect to get back with the warranty.

Each time we consider insurance, including auto insurance, we need to decide whether the inability to bear the risk involved is sufficient enough to justify the extra money that we will pay for the insurance given that the expected value of the policy will not be in our favor, meaning that it will cost us significantly more than we may expect to get back.

Auto Insurance and Expected Value

This really isn’t a difficult calculation but the mistake that people tend to make is to not pay enough attention to the real costs of the insurance and only look at covering the risks regardless of whether they may be big enough to want to worry about and to wish to pay more for.

Product warranties are a perfect example of this and a lot of people purchase them without thinking too much about it. They may even have similar coverage through purchasing item with their credit card but are often not even aware of this.

Selling extended warranties are a big source of profit for retailers, and while insurance is profitable overall, these warranties are particularly nice for them since they aren’t really priced by market forces but rather by people’s willingness to not think that much about the value here and just pay the price that is asked.

With auto insurance, there are some aspects of it that definitely involve events that we are unable to bear the risk for, and there are some other situations that are more like extended warranties where we’re just paying extra money without getting enough value.

We need to look at the amount of financial discomfort or pain that may happen if a certain event, known as a peril, occurs, and then realize that protecting against this is going to cost us considerably more if we insure, and decide whether making these events bearable is going to be worth it to us.

We can always manage the smaller stuff well and in fact the insurance payments are going to involve the smaller stuff in themselves, but things involving larger costs such as losing the entire value of the vehicle in an accident or injuring someone where we are to blame and being exposed to the risks of very large financial settlement that we could never pay are going to be things that we need to worry about, even though the probability of them may be low or even extremely low.

This is the real purpose of any insurance, including auto insurance, which is to protect us against risks we cannot bear ourselves. This may seem obvious but people often do not think of insurance policies in these terms and will instead seek out to manage all risks with one, those they cannot bear as well as those they can easily handle.

An excellent example of this is situations where insurers offer deductibles, where the insured bears a small part of the cost if a claim is made, $500 or $1000 for instance. People may choose a smaller deductible than is offered or even choose not to pay a deductible and they think that this is somehow better for them because it’s just better to have the insurance company pay more or the whole thing, but the truth is, they just haven’t thought very well about the costs and value involved.

Having to pay these small amounts should never be a concern actually, and we will always pay quite a bit more for this than we may expect to get back because that’s how insurance works. Taking on the deductible lowers our premium costs and this means that not doing so will have us paying more, and we may certainly expect to pay several times the premium in extra payments to obtain this coverage.

The expected value with any insurance will always be negative, meaning that we may expect to pay more than we get back on balance, and this is actually a form of a negative returning investment which we voluntarily engage in, for the sole purpose of managing risk.

Managing Risk with Auto Insurance in Action

When we look at things like getting collision coverage or comprehensive for a vehicle that really isn’t worth a lot of money and one that we are not going to be placed in too bad of a situation, or when we decide on what sort of deductible we may choose, we need to be thinking clearly about this and ensure that we properly understand the purpose of auto insurance which is to protect us against unacceptable risks.

It is only when we view insurance this way that we can put ourselves in a position to make sound decisions about it. Some decisions will be easy, for example getting full coverage on a new car, but many of the choices we make here will require some thought and for us to be at least fairly informed.

It’s not really required of us to make any sort of sophisticated calculation here, but rather to have a good sense of what the consequences are. We can actually just assume that the expected value will be significantly against us whenever we add any coverage, because the insurance companies have designed it that way, and you can bet that they use the most advanced analytics to decide this.

Our decisions need to instead be based upon the consequences of not choosing the coverage. If it may cost us an extra $500 if we have an accident, we already know that if we seek to protect ourselves against spending this money, we’ll pay a lot more than $500 per incident on average, so it really comes down to our being able to bear this loss or not without significant enough consequences.

Even if we don’t have the money for this, we can set aside a little each month instead of giving it to the insurance company, or perhaps look to borrow the money where the interest required on the borrowing will still cost us less than the cost of adding this coverage.

If we drive an older car which we own outright, we may not be too concerned with it being totaled in an accident or stolen, and while these are never pleasant events, paying much more than the vehicle is worth in auto insurance premiums isn’t either, and may be the lesser of the two choices in many cases.

Whenever we think of perils, we naturally tend to focus on the peril itself, rather than looking at both sides of the matter and realizing that we need to compare the costs and consequences of each. Being subject to losing a few thousand dollars may not be that big of a deal in many cases, and while at first glance we may think that it’s preferable to be covered against this, we cannot forget that it will cost us even more over time to purchase this.

This Really Comes Down to the Consequences

It’s not hard to imagine someone being in a situation where losing a car worth just a few thousand might present an unacceptable situation. If one requires the vehicle to work and cannot qualify for a loan to buy another car, this could end up putting someone in a very bad spot.

This is generally not the case though but in order to discover whether or not insuring a vehicle against something makes sense or not we need to be thinking about what the consequences of our not buying a particular coverage may be and what the real risks are.

Ideally, we want to improve our financial situation so that we can bear more risks, either by accumulating savings or at least having the capacity to borrow should we need to. There are people who are wealthy enough that they may not even need to worry about auto insurance at all, if they can easily bear the risks involved, losing the entire value of the vehicle or even the risk of large settlements against them should they injure or kill someone and be held financially responsible.

With the great majority of auto owners though, there is going to be a threshold where they are not going to be able to bear financial risks, and these are the ones that it makes sense to insure against.

All we really need to do in order to determine whether certain auto insurance coverages, or any insurance coverage for that matter, is worth purchasing, is to simply ask ourselves what would happen if the event that is sought to be protected against occurs, and decide whether it is worth paying more than the cost of the incident to ensure that we aren’t placed in a bad situation.

Protecting against these risks, the ones that present too much difficulty to bear, is the proper use of insurance, including auto insurance. Life always presents risks, and the key is to pay more to protect against certain ones that are not acceptable, and only those.

John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.

Contact John: [email protected]

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