A lot of companies offer extended warranties on their products. Are they a good idea? Economists have a particular take on this question, a decision involving risk, uncertainty, and information asymmetry. When the sales assistant offers us this service he is not lying but he is feeding us the information that favours the company. Companies respond to incentives and logically they will price the warranties so that they will make a substantial profit on them.
Here is an alternative to the warranty:
Step 1 When you purchase an item, make note of the cost of the extended warranty but don’t buy it.
Step 2 Transfer the amount you would have spent to an interest-bearing reserve account that you cannot touch until one of your gadgets breaks down.
Step 3 Pay for the repairs using he money you have accumulated in your account. And you won’t even have to argue with the shop assistant whether a certain type of damage is covered.
The advantage of this self-insurance is that you are pooling your risks. This is what the retailers do to make sure warranties are profitable for the company. They know that not every customer will take advantage of their extended warranty and the same should apply to your self-insured items. I remember reading somewhere that the Hertz car rental agency doesn’t insure its own cars. They own so many vehicles that its risks are sufficiently spread – there would be no point in paying an insurance company to assume those risks. Hertz is able to use the same statistical methods used by insurance companies to determine the financial costs of its risk and it incorporate those costs into what it charges its customers. An insurance company would incur administrative expenses and of course they need to make a profit
Of course you may be extremely unlucky or highly careless not every product you self-insure will break unless you are extremely unlucky or very careless. Or maybe the thought of your 66-inch plasma TV breaking down brings you out in a cold sweat. In that case you may be better off with the extended warranty.