I recently wrote a blog post discussing the high cost of “extended warranties” or “replacement insurance” on small items.  The basic premise of my post was that (generally speaking) the lower the the value of an item you are purchasing, the higher the extended warranty cost will be for that item (as a percentage of the item’s value).  I generally warned people against such plans but did provide a framework of how to assess whether it would be worth purchasing such a warranty, as there could be rare times when it makes sense (if it had taken a while to save for the item and you would intend to replace it if ever lost– or if like me, you have a penchant for consistently misplacing certain items regularly, like your cell phone).

Just the other day, I saw a great article in The Dallas Morning News entitled “Shop Around before buying an extended electronics warranty” that reinforces much of what I wrote pertaining to extended warranties on merchandise purchases, and also provides more information about these extended warranty products.

I agree with the article’s title, because if you feel like you must buy an extended warranty, then you should treat the purchase of the warranty just like you often treat the purchase of the device: shop around first!  The article also provides some helpful guidance along those lines from Consumer Reports, which “says 20 percent of the purchase price of the covered item is the max that anyone should pay for an extended warranty.”

Here is an excerpt from the Dallas Morning News article:

Shoppers are predicted to spend $1.3 billion on extended warranties for electronics and appliances this holiday season, according to industry journal Warranty Week.

Many of those sales will occur at the cash registers of retail stores where otherwise well-educated shoppers unthinkingly agree to inflated warranties.

“Consumers will spend months and months looking for the best deal [on an electronic gadget], waiting for it to go on sale,” said Geoff Green, president and chief executive at Dallas-based Extended Warranty Group.

“And then that same person will spend double what they should on the warranty.”

The gentleman quoted in the article’s excerpt above, Geoff Green, leads the company behind www.electronicwarranty.com, an alternative source to the extended warranties that are often pushed heavily on consumers at the checkout in stores.  This to me seems like a very good business idea, and one that pays off for consumers– Mr. Green clearly recognizes that stores are pricing these warranties far too high and has provided another way for consumers to get coverage on such items at a more reasonable cost.

The lesson is this: put some energy not only into shopping for the best price for the item, but also shopping for the best available warranty by looking at sources of warranty coverage beyond the retailer itself — sources such as www.electronicwarranty.com

Happy shopping!

This product, for a percentage point or two of the value of the home when purchased, will insure you against loss of value.

The companies offering this product, I would guess, are betting the success of this product on a couple of strategic assumptions:

1.  It assumes that there is a decent chance that a home buyer is only considering staying in their home a short period of time, probably 5 years or less, before moving to a different city, a different place in their city, or to a larger home.  If someone plans to move in just a few short years, they may be more likely to purchase this insurance to protect the potential “down side” they would experience if their local housing market tanked and their house plummeted in value right as they were needing to sell it.  Rather than having to come up with funds out of pocket, this insurance plan would provide for them.

2.  The plans are catering to buyers with little down payment.  While most home buyers with substantial down payments would never dream of buying home value insurance, individuals with little or no down payment often understand the risk they are taking and would like to have a way to mitigate that risk.  They don’t want to find themselves in the same situation as their old neighbor, or as their near-bankrupt relatives who paid dearly to sell a depreciated house they couldn’t afford due a simultaneous drop in the housing market and loss of their own job and income.

While home value insurance may be helpful for some, if you buy a home you plan to live in for a while– and if you buy it with a decent down payment, there’s no need for these products and it adds yet more costs related to the home purchase transaction.  Ironically, one of the major arguments to staying in a house for a while before selling is that the real estate transaction cost incurred when you sell makes up a smaller percentage of your home’s equity than it would over a longer period of time. And yet this product, which itself aims to protect your equity position in your home, just adds to that cost burden.

It will be interesting to see how these products progress — will insurance regulators step in to regulate these products as what they are (insurance!), and what will be the opinion of personal financial coaches and advisors are on these products in the coming years…?  Time will tell.

Of course, many professionals would say that the problem of not having sufficient insurance is much more widespread.

So, I have attempted to create a chart here that lays out WHAT insurance most people need and WHEN in their lives they will need it, and I will further explain the rationale behind holding each type of insurance below the chart.  Note that this information is not a substitute for professional advice based on your particular situation, but rather for informational purposes only.

TYPICAL INSURANCE NEEDS ORGANIZED BY LIFE STAGE

Automobile Collision Insurance: Most people think of automobile insurance as “automatic”–something they will get and must get if they own and drive a vehicle.  That IS true in almost every state when it comes to liability coverage, which covers costs related to other individuals’ involved in an accident that is determined to be your fault.  You definitely want to maintain liability insurance, as lawsuits and other issues could drive up claim amounts to high levels unpredictably.  However, collision insurance is designed to cover damage to YOUR vehicle when you are at fault in an accident, and is not actually required in most states.  If you own a vehicle outright, and have no loan you owe money on, you can very likely opt NOT to have collision coverage.  This makes sense to do if you can stomach potentially writing a check for the full cost of a replacement vehicle in the unfortunate event you cause an accident that totals your car.  Many people in their 50′s, 60′s and beyond self-insurance all automobile incidents, as they have sufficient wealth to cover such incidents without it drastically affecting their assets or lifestyle, and they know they will very likely spend less over the years than by paying collision insurance premiums year after year– particularly if they have historically been a safe driver.

Health Insurance: Regardless of where you stand on this hot-button issue philosophically and politically, the fact remains that if you are able to hold health insurance, you should do so.

The TYPE of health coverage you carry, however, may different throughout your life.  If you are self-employed or have an individual policy and are in your 50′s or older, you may find that an insurance plan with a high deductible ($5,000 or $10,000), basically designed to cover major medical issues, is extremely affordable and may make sense to take advantage of if you can afford regular cash outlays for ongoing minor medical needs and medications.  Such catastrophic coverage often costs just a FRACTION of what typical health insurance plans would cost.

There is one important thing to keep in mind with health insurance, however:  One should never attempt to fully self-insure themselves in this area, because the frequency, odds, and costs of medical problems vary greatly and are very difficult to predict.  Even with significant assets at your disposal, those assets could quickly be exhausted with major surgeries and expensive treatments in many situations. Insurance is at its best when it protects individuals against sudden, catastrophic losses that those individuals could not fund themselves.  So, for the best overall cost control, many people in average health will find it advantageous to participate in their employer’s group health insurance plan, or if such a plan is not made available to them, to instead hold a high-deductible individual plan and save for ongoing expenses — either way, they should have some form of health insurance coverage throughout their entire life.

Disability Insurance: The statistics on disabilities are interesting.  I have heard a variety of figures, but a commonly-quoted statistic is that a 30 year old male is greater than four times MORE likely to become disabled than die– and that an American is injured in an accident every 2 seconds.  Many young couples secure the financial future of their spouse should they pass away by securing life insurance, but few purchase disability insurance even though, particularly within an employer’s group disability insurance plan, it is very affordable, typically only a few dollars per week.

Premiums for disability insurance through a group plan should be paid as an after-tax deduction from your paycheck, so that the payout later should you become disabled is also tax-free.  Typically, disability insurance pays 60% of your wage at the time of your disability, but again remember it is tax-free.  There are short-term disability and long-term disability policies available.  If you have a large emergency fund, a short-term plan may not be necessary, but almost everyone of working age needs a long-term plan, as a permanent or long-term disability could otherwise be financially devastating to your family.  Another key issue to consider when buying disability insurance is “occupation specific”– in other words, whether the plan pays you disability payments until you are able to return to your traditional employment or whether it requires you to take work of some sort to bring in some money to help offset disability payments.  This is an important item to be aware of.

In my next post, I will provide basic info on the additional forms of insurance shown on the chart above that are not explained in this post.  Stay tuned!

The key principle to UNDERSTAND about such plans is this: the smaller a loss you are insuring, the higher premium you will pay (as a percentage of the cost or value of the potential) to have it insured.

By contrast, collision insurance on a vehicle may cost many dollars over the course of a year, but very little as a percentage of the value of the car.  You cover more, you pay less (as a percentage of value).  A careful thinking-through of the decision, combined with such an understanding, will almost always lead you to the right decision for your circumstances.

A great example of this is the “extended warranty plan” you are often urged to consider by a Home Depot or Best Buy cashier on a moderately-sized or large purchase–although I have been offered such a plan (for $9) on small appliances costing as little as $50. Another group of products (in their case, primarily sold through car dealerships) includes items such as tire and wheel insurance and paintless dent removal.

What do all such warranty/insurance plans have in common?  They all collect a small amount of dollars from you to cover a relatively minor cost you might later incur.  The problem is this: you are paying an exhorbitant fee to maintain this type of coverage.

For example, paying $50 for 3-year extended warranty on a $250 lawn mower would be fairly typical.  And yet, that would require you to have a major repair issue within 3 years in order to “pay off”.  If you purchased such a warranty every time you bought a lawn mower, it would require you to take advantage of the insurance once for every 5 mowers you purchased in order to make sense.  Is that possible?  Maybe, but the most likely time your mower would need major repairs would be after MANY years of operation–long after the extended warranty you purchased had run out.

Another great example of this is phone equipment insurance.  Unless you are like me (I have been known to break or lose my cell phone every 9 months or so), then this type of coverage would probably not pay off.  Paying $5.99/month more on your phone bill to cover the random chance you back over it with your car, more often than not, will NOT save you money.

There are two ways to analyze such coverage to determine whether it will be financially helpful to you, or not:

1)  Calculate what percentage of the value of the item the coverage is, and think about the odds of damage occurring.  If a clothes dryer costs $400 and the 5-year extended warranty/insurance is $100,  then do you think there is a 1 in 4 chance ($400/100 = 4) of the dryer needing major repairs within 5 years?  If so, then buy the extended warranty.  If not, don’t buy it–it’s as simple as that.

2)  Determine if you could, worse scenario, fork out cash to purchase another of the same item if the one you bought was damaged or destroyed beyond repair.  If being forced to do so would devastate you financially for the week, month, or year, and keep you from paying for important things like a house payment/rent, groceries, etc., then maybe you should in fact insure that item.  This analysis is only sensible if you determine the item must be replaced in the event of loss.

The plans I have been discussing here are purchased by consumers because, quite frankly, the prospect of forking out cash for a new lawnmower, a new phone, or a new set of tires unexpectedly is often devastating to someone who may be living from paycheck to paycheck and the option of such a warranty or insurance plan seems attractive because of the low total additional cost involved.

The preferred method of dealing with unexpected losses on small items, then, is to maintain a savings account, even if just $1,000 or so, to provide a buffer for such unexpected expenses–instead of buying insurance and extended warranties on small-dollar items.  Such a strategy will save you significant dollars over the course of your lifetime.

12/21/09 Update: I recently wrote a blog posting (access by clicking here) with updated information about extended warranty products, including a source for purchasing them that offers better rates than most retailers.