We’ve written many times on the importance of a rational decision-making process in investing. But the same applies to other financial decisions, including those related to insurance. So is it possible to make optimal decisions when it comes to insuring your home or other possessions?
Working out whether to buy insurance, and, if so, how much cover you should go for, can be really challenging. It’s a classic example of how hard we can find it to make rational decisions in the face of uncertainty.
So is there a framework for making these choices systematically and consistently?
Victor Haghani and James White at Elm Partners have examined this question through the lens of expected utility.
Simply put, expected utility is the weighted average of all possible outcomes of a decision, where each outcome is weighted by its probability and its utility (eg, in the case of insurance, value and peace of mind).
Three important principles
It may seem obvious, but an important thing to remember is that insurance companies exist to make a profit. If you could buy insurance at a truly "fair" price (just covering the expected payout), it would make sense to buy as much as possible. But insurance companies always add a “mark-up" to cover their costs and make a profit.
So, when deciding on the level of cover to choose, you shouldn't focus on the total premium, i.e. the price you pay, but on the margin — how much extra you're paying above the fair price.
A second important principle is to view whatever it is you’re thinking of insuring in relation to your overall wealth. Insuring big risks — your house, for example — is much more important than insuring, say, a smartphone or a dishwasher.
A third principle is to keep your decision-making rational and not let your intuition lead you astray. For example, beware the temptation to reduce coverage when the insurance premium goes up due to increased risk of loss rather than an increase in the margin charged by the insurance company.
Working out the optimal level of cover
How, then, do you calculate the optimal level of insurance?
“The insurance decision,” the authors write, “is primarily a function of the size of the hazard relative to your total wealth, your risk-aversion, and the margin in the insurance policy being considered.”
Bear in mind that Haghani and White are investment, rather than insurance, specialists. But their research is well worth reading, and they’ve also built a calculator to help inform your insurance decisions.
You can find out more in this article on the Elm website:
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