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MNBoxster:
"It is simply insurance by another name, and as such, is predicated on the fact that fewer people will make claims than those actually taking out the warranty."
Jim, I agree with you and bnorman but the answer is not absolute and needs to be analyzed on a case by case basis. Extending the argument to all insurance is a bit more complicated as both the AVERAGE and the VARIANCE of the random outcomes need to be considered. Sometimes it "pays" to buy insurance when the volatility (variance) of the unknown outcomes becomes too large. For instance, let's assume that the average annual house insurance claim is $1000 (per house per year) and the average annual house insurance premium is $1500 (per house per year) -- just inventing numbers here. The insurance company is making $500 (per house per year) profit. However, imagine that the volatility (variance) of the claims is such that $300,000 claims are still very likely every year (even though the average is still only $1000). Paying the extra $500 per year to GUARANTEE that you will never be losing $300,000 is not a bad idea in this case -- even if you had the $300,000 saved in a 'catastrophic loss' account.
Now the $500 (33% profit margin) may be excessive but that's really a question on how free the market is and how much competition is allowed in the insurance business. More competition would cut that margin down, of course.
My point is that when the volatility becomes much larger than the mean (average) of a random process, and especially when it becomes comparable to someone's net worth (or even larger), then it's worth paying a premuim over the 'cost' premium to avoid it.
Z.
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