Insurance Policy – Part I

Something Interesting about Insurance Policy. I have always wondered how the Insurance works and I have written previously also many articles regarding the same. This is just to give you a better view of things.

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Let’s discuss some case studies here:

Case A:

Suppose I give you a choice to make of the 2 available options:

  1. A bet in which you will surely loose 50 Rs. (100% chance of loss)
  2. A bet with 25% chance of Loss of 200 Rs, and 75% chance of Zero Loss

Which one will you choose? Think about it carefully, before making your choice and before reading further.

Some people select choice 1, other select choice 2. What have you selected?

Well, 98% of the people select choice 2 – so if you have done so, Congratulations – you are with the majority. But is majority always right? No, not necessarily, and not always. The psychological reason why more people select option 2 is because there they see a 75% chance of Zero Loss. They believe that there is more chance of saving a loss (75%), and it is better than a sure (100%) chance of loss of 50 Rs. The first illusion that comes to mind is that it is wise to take a 75% chance, rather than a sure loss.

However, mathematics works in its own ways. If we take the VALUE of the above two choices, we have the following:

  1. 100% * (-50) = -50
  2. 25% * (-200) + 75%*(0) = -50

Basically, what this means is that both the options are exactly the same, as far as mathematics is concerned. If someone asks me how much I will be willing to pay for entering this bet, I’ll say 50 Rs for both.

However, our psychological biases force us to look only at the things that we perceive are good, not necessarily the once that are really good. We do not know how to value an investment or a product, the only thing we look at is who is offering the product (a reputed investment bank, fund house or insurance company), who all are talking about and taking the policy (our colleagues, friends, relatives, even agents and brokers) and how has the product done in the past. What we forget is that there MAY not be any relationship between the efficiency of the product with its popularity, and with its past results – like a Mutual Fund performing better in the past does not guarantee similar returns for a coming year in the future. We tend to base our judgments on these factors completely ignoring the realities.

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3 thoughts on “Insurance Policy – Part I

  1. Firstly, some feedback about your site – some pages take really long to load thus making it inconvenient for a reader to keep flipping articles. I would advise you not to break posts (at least the small ones) into 2/3 parts. At least that way, you can ensure that people read up all the parts and get the complete idea about what you are trying to say 🙂

  2. Ravi says:

    Good article, explains in detail why we should keep emotions aside while making financial decisions!
    Just one problem with your case , even in the best case I am not gaining anything, I just get my money back! Why would I take part in a bet where I don’t stand to gain anything!
    And if you mean to say that insuring and betting are similar then again I beg to differ!

  3. Saravanan says:

    @Shashi : I shall keep that in mind and look into it in the future.

    @Ravi : Agreed with your point. Given an option to choose between the two, what would you choose was the question and not anything else. I know that you wont choose an option to lose, anyone would do that.

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