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Insurance companies are businesses and their goal is to make money. It follows that if you are neither lucky nor unlucky, you will end up in the long run losing money by stipulating an insurance. I think this is a very simple concept that cannot be disputed, even though every time I try to explain this the other person starts saying how their mom/friend/aunt/etc saved a lot of money by buying insurance.

Now, it seems to me that insurance makes sense only if you cannot recover from a loss without it; for example, if you are a taxi driver with little to no savings it would make sense insuring your taxi against theft, because if you lose your taxi then you are pretty much screwed.

But why do rich people do it too? For example, a friend of mine who has tons of money saved up, insured his car for $1400, 4% of the value of the car, each year. According to a website I found much less than 0.25% of new vehicles are stolen during their lifetime, and in almost all occurrences the thief had access to the original key.

This person could buy another car at any moment without any money problems, so I don't really see any point in insuring, especially with such a ridiculously high price compared to the extremely low risk.

Why do people do it? It's just like gambling, but reversed. If you go to the casino long enough you'll lose money; if you insure long enough, you also lose money.

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I think your premise is flawed. You are not guaranteed to lose money buying insurance just because insurance companies are profitable. Insurance companies make money in aggregate, not necessarily on every customer. –  JohnFx May 15 '11 at 21:26
Insurance companies also profit from earnings on their investments -- the money paid in from premiums is invested in various ways. –  bstpierre May 15 '11 at 22:03
@JohnFx: I never claimed that. I specified several times "long enough", "neither lucky nor unlucky", etc. –  Andreas Bonini May 15 '11 at 22:09
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5 Answers

There are a couple of reasons that a person might choose to use insurance even if they could handle the financial loss if something went wrong.

  1. They know their risk better than the insurance company. While it might seem odd at first glance that an individual can be better at assessing risk than a large company with thousands of actuaries. There are limits to the amount of knowledge that an insurance company can have or use to price their insurance products. For instance if you were a very aggressive driver but didn't have any recent tickets or accidents because you were in college and didn't have a car on a regular basis, but now you have a job and drive 30 miles to work every day. You know your risk is relatively high but the insurance company sees you as relatively low risk and aren't able to price that extra risk into your premium.

  2. Just because a person can survive financial after losing something like a car or a house doesn't mean it isn't desirable to pay a small price to mitigate that risk. If you are using your savings to pay for an emergency then that money needs to be semi liquid in case you need it limiting your investment options. Where as if you purchase insurance you pay a small amount of money to be able to invest the rest of your money. Liquidity is a big deal particularly if you are a small business and investing into your business where your money can make your more money but you may or may not be able to access that money very easily.

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+1 for the second point. The value isn't always limited to the cash value, sometimes the value is the peace of mind. –  MrChrister May 15 '11 at 18:23
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For a car, you're typically compelled to carry insurance, and picking up "comprehensive" coverage (fire, theft, act of god) is normally cheap. If the car was purchased with a loan, the lender will stipulate that you carry comprehensive and collision insurance.

People buy insurance because it limits their liability. In the grand scheme of things, pricing in a fixed rate of loss every year (insurance premium + potential deductible) is appealing to many versus having to cover a catastrophic loss when your car is wrecked or stolen.

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Your basic point is correct; the savvy move is to use insurance only to cover losses that would be painful or catastrophic for you. Otherwise, self-insure.

In the specific example of car insurance, you may be missing that it doesn't only cover replacement of the car, it also covers liability, which is a hundreds-of-thousands-of-dollars risk. The liability coverage may well be legally required; it may also be required as a base layer if you want to get a separate umbrella policy up to millions in liability. So you have to be very rich before this insurance stops making sense.

In the US at least you can certainly buy car insurance that doesn't cover loss of the car, or that has a high deductible. And in fact, if you can afford to self-insure up to a high deductible, on average as you say that should be a good idea.

Same is true of most kinds of insurance, a high deductible is best as long as you can afford it, unless you know you'll probably file a claim. (Health insurance in particular is weird in many ways, and one is that you often can estimate whether you'll have claims.)

On our auto policy, the liability and uninsured motorist coverage is about 60% of the cost while damage to the car coverage is 40%. I'm sure this varies a lot depending on the value of your cars and how much you drive and driving record, etc. On an aging car the coverage for the car itself should get cheaper and cheaper since the car is worth less, while liability coverage would not necessarily get cheaper.

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All investors have ultimately the same investment goal: maximize returns while limiting risk to an acceptable level. Of course we would love to maximize returns while minimizing risk, but in most cases if you want higher returns you must be willing to accept higher levels of risk. We must keep in mind that investors are humas, not computers. As such not everybody is willing to accept the same level of risk.

Insurance is simply a way to "buy down" risk. Yes, it reduces our overall gains (most of the time), but so do bonds vs stocks (most of the time). And yet who among us doesn't have bonds in our portfolio? Insurance is yet another way to balance risk and return.

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Insurance isn't a product designed to protect against financial loss. The product is designed to allow people to pay a small fee (the premium) for piece of mind. This allows the insured to feel as if their purchase was worthy (they see the potential of loss as a concern and the premiums small enough to allow them to not worry about having a loss).

Insurance companies will then seek out insurable risks where the perceived losses far out weight the actual losses (risk assessment).

So, you answer is that your friends are paying for piece of mind.

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