Thursday, December 7, 2006

Advice for Young People; Buy Renters Insurance

For the last few years I have been posting random musings on a system of blogs that was only accessible to Grinnell College community, well perhaps its time to move on since instead of being a student I am now a Professor. Actually I will still post there, but this will be different. Unlike my Grinnell postings this will be written in my professor persona. However, one thing I always liked about Professors at Grinnell is that they shared great examples from everyday life to teach students their subjects.

With that in mind, here was the subject of my Economics 199 lecture yesterday. In economics we use a term called risk aversion. That means that sometimes some people will be willing to pay money to avoid a risk, these people are called risk averse. I asked my students today how many people in the class would be willing to play a lottery where for $1 they would have a (1/1000) chance to win $1000. Many students wanted to play the lottery. However, when I asked how many students would run a lottery where you get a $1, but you have 1/1000 chance of losing $1000, most students did not want to run such a lottery. Yet in either game the average amount won is $0. This simple example teaches us that my students want to avoid risk.

Now imagine someone knocks on your door one day. They tell you that they want to play a game with you. They will pick a number from 1/20,000 if they guess correctly they win all of your possessions if they guess incorrectly they will give you $200. Say all your possessions are worth 10,000 (clothes, furniture, and electronics). Now the expected payoff of this game is greater than zero in fact it is really close to $200. However, if we were unwilling to run the $1000 lottery game we would probably be unlikely to play this game either. (Plus who takes bets with someone who knocks on their door.)

Basically by not purchasing renters insurance you are playing the game. You could not give the insurance company $200 for a policy (that is like the $200 the stranger gives you), but you take the chance of losing all your possessions in a fire or being robbed.

Yet only 30% of renters carry insurance. Are people less risk averse than me (I have renters insurance)? Do people not realize that their landlord doesn’t cover their possessions in case of fire, flood, or robbery. I don’t know, but it seems again sometimes economic theory might not explaining what is going on in life.

1 comment:

Bob Gitter said...

Congratulations on your new Blog. Glad to be the first to post a comment. The problem with renter's insurance is that the seller not only figures out a profitable price to charge in light of the odds, they also must cover the costs of adminisering the policy as well as generating a profit. After this, it could easily result in a price that is not a good one for the renter. This is why I never buy an extended warranty on a product.

Beyond this, let me say after many years of college teaching, there are a great number of people who just can't figure out the numbers.