Console Insurance Is A Ripoff

Back of envelope financial calculations: Warranties, fine; insurance, no!
statistics, decision-theory
2009-03-102012-02-02 finished certainty: highly likely importance: 4

Con­sider the poor con­sumer con­sid­er­ing ‘insur­ance’. Insur­ance is offered for all sorts of things, and often the con­sumer buys it—even when he should­n’t. One of the prob­lems in an inef­fi­cient mar­ket­place—­like the ones we often must pur­chase in—is that there’s a of sorts in play: if the insur­ance was ‘fair’, the insurer would make no prof­it, so why would they offer it at all? They’ll only offer one which makes them a prof­it. There­fore, all the insur­ances on offer are unfair (you’ll get less out of it than you paid) and you should­n’t buy any!

Of course, we know why one would pur­chase insur­ance: because the risks one is insur­ing against are too large to be borne at any given time (even though one can pay for them even­tu­al­ly). A house burn­ing down, chemother­a­py, a car totaled, etc. One buys insur­ance as a way to trade many small doable pay­ments for a sin­gle large impos­si­ble pay­ment. This is a valu­able ser­vice to you, so you don’t mind buy­ing ‘unfair’ insur­ance; your lower is traded off against a smaller of your future expens­es. (Peo­ple are well known to be ; the rich are less so than the poor, which is sad1.)

But not all insur­ance is of the ‘cat­a­strophic’ vari­ety. I’ve seen insur­ance offered on travel trips, air­plane flights, TVs, and even video game con­soles! And that insur­ance is expen­sive, dozens or hun­dreds of dol­lars. It’s strange that peo­ple appar­ently think they can afford the steep insur­ance fees but not bear the cost of just buy­ing a new con­sole or what­ev­er. The irony is espe­cially rich when one con­sid­ers that peo­ple grossly over­es­ti­mate how unhappy they would become after major trau­mas, and also smaller losses2; how much less so if their iPod or Xbox broke? This is prob­a­bly due to the ; espe­cially ironic is that insur­ance—the option to change one’s mind—­may sab­o­tage one’s enjoy­ment of the pur­chase3.

These pur­chases make no sense from the orig­i­nal ratio­nale for buy­ing insur­ance. Nor are these insur­ances triv­ial side-­lines com­pa­nies run to humor their con­sumers: they are pop­u­lar ser­vices (~31%4 of pur­chases in one sam­ple), and they are highly prof­itable5.

Worst Buy

Let’s look at a real exam­ple. The smaller the good, the more obvi­ously a bad deal these kinds of insur­ances are. I recently saw offers of con­sole insur­ance at (sand­wiched between $100 cables), and was struck at how exploita­tive the offer must be. (Best Buy is noto­ri­ous among geeks for its extra­or­di­nar­ily high prices and poor cus­tomer ser­vice6.)

What a deal

The price varies per item, but let’s take a pre­sum­ably com­mon one. As of 2009-03-09, offered an for $399.99. The basic insur­ance plan on that Xbox 360 will run $59.99. That is, you will pay ~16% extra for insur­ance (). And it’s good only for 2 years or so. What does this con­sid­er­able pre­mium buy you?

Our oblig­a­tions under this Plan will be ful­filled in their entirety if we replace your pro­duct, issue you a voucher or gift card or reim­burse you for replace­ment of your prod­uct pur­suant to these terms and con­di­tions.

It buys you one replace­ment; or:

After three qual­i­fied (3) ser­vice repairs have been com­pleted on an indi­vid­ual prod­uct and that indi­vid­ual prod­uct requires a fourth qual­i­fied (4th) repair, as deter­mined by us, we will replace it with a prod­uct of com­pa­ra­ble per­for­mance of like kind and qual­ity not to exceed the orig­i­nal pur­chase price.

3 repairs and a replace­ment. And that’s it. But of course, it’s not uncon­di­tion­al. You can’t sim­ply walk into Best Buy after a few days and announce you want a new Xbox 360. Here’s invalid rea­sons to seek repair:

This Plan does not cov­er:

  1. dam­age to your prod­uct caused by acci­dent (un­less you have pur­chased the optional ADH Cov­er­age), abuse, neglect, inten­tional phys­i­cal dam­age, mis­use (in­clud­ing faulty instal­la­tion, repair, or main­te­nance by any­one other than an autho­rized ser­vice provider), unau­tho­rized mod­i­fi­ca­tion, virus­es, extreme envi­ron­ment (in­clud­ing extreme tem­per­a­ture or humid­i­ty), exter­nal con­den­sa­tion, light­ning, sta­tic elec­tric­i­ty, fire, flood, insect infes­ta­tion, rodents, war, ter­ror­ism, com­puter soft­ware related fail­ures (un­less you have the Vi-Spy Cov­er­age) or other exter­nal caus­es;
  2. prod­ucts that have been lost or stolen. This Plan only cov­ers prod­ucts that are returned to us in their entire­ty;
  3. cos­metic dam­age to your prod­uct includ­ing but not lim­ited to scratch­es, dents and bro­ken plas­tic on parts, that does not oth­er­wise affect its func­tion­al­ity or mate­ri­ally impair your use;
  4. prod­ucts with a ser­ial num­ber that has been altered, defaced or removed;
  5. prob­lems caused by a device that is not your pro­duct, includ­ing equip­ment pur­chased at the same time as your pro­duct;
  6. con­sum­able parts, such as bat­ter­ies, unless expressly pro­vided for here­in;
  7. dam­age to, or loss of any soft­ware or data resid­ing or recorded in your pro­duct…
  8. dam­age to your xBox 360 due to Microsoft’s ‘

Well, shucks. That seems to cover just about every­thing that would dam­age my new Xbox 360! If it ships bro­ken—as is extremely likely and seems to cover almost all of the reported break­age rates7, then it’s the orig­i­nal man­u­fac­tur­er’s prob­lem (Mi­crosoft); if I break it by acci­dent, it’s my prob­lem; if it gets scratched up, it’s my prob­lem (and god help me if the scratches are any­where near the ser­ial num­ber! Then I can’t use the plan at all!); if my house dam­ages it, it’s my prob­lem; if one of the many mechan­i­cal and elec­tronic prob­lems with the Xbox man­i­fests, it’s either my or Microsoft’s prob­lem; etc. This does­n’t seem to cover very much, although I sup­pose it cov­ers if my Xbox stops work­ing for no rea­son what­so­ever one day. (Which isn’t a ter­ri­bly com­mon prob­lem with video game con­soles.)

We’re inter­ested not in what hap­pens if we get lucky and imme­di­ately the Xbox 360 breaks and the man­u­fac­tur­er’s war­ranty does­n’t cover it and Best Buy will give us a new one8—after all, if we only go by best case sce­nar­io, the lot­tery is the great­est deal around—but rather in what we can expect on aver­age; we have no a pri­ori rea­son to expect to be luck­ier or unluck­ier than aver­age. So we use the expected value for­mu­la:

Gen­er­al­ly, one only wants to engage in deals or actions which have a pos­i­tive expected val­ue. Does the Xbox insur­ance have a pos­i­tive val­ue? Let’s say I have no idea of the true rates9. Cer­tainly nei­ther you nor I have access to good infor­ma­tion about how many of Best Buy’s cus­tomers actu­ally use the insur­ance suc­cess­fully (although Best Buy surely does). But we can still put some bounds on it: we can ask the ques­tion, “how likely would Xbox-break­ing have to be before the insur­ance has a pos­i­tive pay­off?” That is, we know the pay­of­f—it’s 340. And we know the expected value we want by def­i­n­i­tion is for it to be greater than 0; but we want to get more out than we put in, so we need to get back at least $60 if we want to just break-even. With 2 out of the 3 vari­ables solved, basic alge­bra can now fig­ure out the final vari­able, the prob­a­bil­i­ty:

More details

So we need a 1-in-6 chance of redeem­ing the insur­ance. But wait! The 1⁄6 does­n’t apply directly to the chance of break­ing an Xbox. Rather, it applies to the con­junc­tion I expressed before: break­ing the Xbox and Microsoft not cov­er­ing it and Best Buy mak­ing good10 and us actu­ally using it. As we all know, a con­junc­tion of a bunch of prob­a­bil­i­ties is going to be less likely than any of the prob­a­bil­i­ties in them­selves. So the first prob­a­bil­i­ty, ‘break­ing the Xbox’ is going to be more likely than just 1⁄6.

How much more like­ly? Well, we can play with some more num­bers here. Let’s see what hap­pens if we are very gen­er­ous & assign all the other prob­a­bil­i­ties some­thing like a 90% chance. We know the total is 1⁄6, and we know the other 3 we’ve defined to 0.90, and we leave one vari­able to solve for, ‘break­ing the Xbox’ ():

So just by being a lit­tle more real­is­tic, we see that for the insur­ance to make sense, we need an awfully high rate of Xbox break­age. And the nec­es­sary break­age rate for us to break-even becomes still worse, still more incred­i­ble, if we were to be less gen­er­ous in the con­junc­tion.

I don’t know about you, but I don’t believe I have a 1 in 4 chance of break­ing my new Xbox within the 2 years the insur­ance cov­ers. I believe the chances are much lower11. And that makes this insur­ance one lousy deal.

Deeper down the (rabbit) hole

Nor is con­sole insur­ance the worst offer Best Buy has. It recently (Feb­ru­ary 2011) began a curi­ous buy/lease pro­gram12. In this scheme, the cus­tomer pays 10% up front, and in exchange, if the cus­tomer returns the item for any rea­sons within 6 months, Best Buy will give them a 50% dis­count on a new/replacement item. It’s hard to see who this trade-in offer is for. One’s time is not free and one does­n’t want to switch prod­ucts too fre­quent­ly; and if we assume gen­er­ously that a com­pelling new prod­uct comes out ran­domly every 2 or 3 years, the num­bers are even worse.

  1. Chen et al 2009:

    The results from the het­ero­gene­ity analy­sis are intrigu­ing. In con­trast to prior empir­i­cal find­ings (Pad­man­ab­han 1995; Pad­man­ab­han and Rao 1993), we find that, as com­pared to high­-in­come con­sumers, low-in­come con­sumers are more likely to pur­chase ESCs. The analy­sis reveals that they are likely to do so because they are more sen­si­tive to the replace­ment costs in the event of prod­uct fail­ure. Unlike in the case of auto­mo­biles, where high­-in­come con­sumers buy ESCs to avoid main­te­nance because they have higher time costs, in the elec­tron­ics prod­uct cat­e­go­ry, low-in­come con­sumers buy insur­ance to hedge against the out­-of-pocket costs of replac­ing the prod­uct. Addi­tion­al­ly, low­er-in­come con­sumers are also more pre­dis­posed to exer­cise the sav­ings obtained from pro­mo­tions to pur­chase ESCs.

    If the ESCs do, in fact, offer lit­tle val­ue, the results imply a per­verse impact on con­sumer wel­fare. The lack of finan­cial abil­ity of low-in­come con­sumers to replace prod­ucts induces them to pay a poten­tially unnec­es­sary and over­priced insur­ance pre­mi­um. High­-in­come con­sumers, for whom prod­uct replace­ment is not a cause for anx­i­ety, incur a lower total cost of prod­uct acqui­si­tion. These find­ings are some­what ironic in light of obser­va­tions that poor sick patients who are unable to afford health insur­ance pay the high­est prices for drugs (e.g., Frank 2001). In the health domain, poor patients are unable to afford insur­ance in a cat­e­gory where it is salu­bri­ous to buy it, but they opt for insur­ance in an area where the invest­ment is inex­pe­di­ent.

  2. “If money does­n’t make you hap­py, then you prob­a­bly aren’t spend­ing it right”, Dunn et al 2011, Jour­nal of Con­sumer Psy­chol­ogy:

    Research on how well peo­ple cope with a wide vari­ety of trau­mas and tragedies-from heart attacks to ter­ror­ist attack­s-­sug­gests that peo­ple are not the emo­tion­ally frag­ile crea­tures they often imag­ine them­selves to be (Bonan­no, 2004; Ubel, 2006).

    …re­search sug­gests that peo­ple don’t know much about their own psy­cho­log­i­cal immune sys­tems (Gilbert, Pinel, Wilson, Blum­berg, & Wheat­ley, 1998), and as a result they over­es­ti­mate their vul­ner­a­bil­ity to neg­a­tive affec­t…re­search shows that this expec­ta­tion is wrong. Ker­mer et al. (2006) gave par­tic­i­pants $5, and then flipped a coin. Par­tic­i­pants were told that if the coin came up one way they would get an addi­tional $5, and if it came up the other way they would lose $3 of their ini­tial endow­ment. Although par­tic­i­pants expected to be more emo­tion­ally affected by the loss of $3 than by the gain of $5, they were not.

    …When pas­sen­gers on a train were asked to esti­mate how much regret they would feel have felt if they had missed the train by 5 min­utes or 1 min­ute, they esti­mated that they would have felt more regret in the lat­ter case than the for­mer. And yet, pas­sen­gers who had actu­ally missed their trains by 1 and 5 min reported remark­ably lit­tle regret, and equally lit­tle regret regard­less of whether they had missed the train by 5 min or by 1 (Gilbert, Morewedge, Risen, and Wil­son 2004).

    For another good exam­ple of peo­ple fail­ing to under­stand them­selves, see the next foot­note on how return poli­cies (and thus warranties/insurance?) can sab­o­tage one’s sat­is­fac­tion with a pur­chase.↩︎

  3. Dunn et al 2011:

    Unfor­tu­nate­ly, this handy men­tal mech­a­nism may actu­ally be short­-­cir­cuited by gen­er­ous return poli­cies. offered par­tic­i­pants the choice between prints of paint­ings by artists rang­ing from Van Gogh to El Gre­co. After par­tic­i­pants made their selec­tion, half of them were pre­sented with the equiv­a­lent of a gen­er­ous store return pol­i­cy: they were told, “If you change your mind about which poster you want to take home before you leave today or even any time in the next mon­th, you can just let me know and we will exchange it for you.” The remain­ing par­tic­i­pants were informed that no such exchange would be pos­si­ble and that their choice was final. Par­tic­i­pants who knew they were stuck with the poster they had cho­sen responded by inflat­ing their appre­ci­a­tion of it, see­ing the poster in a more pos­i­tive light than they had ini­tial­ly. In con­trast, par­tic­i­pants who knew they could exchange their poster any­time were deprived of this emo­tional ben­e­fit of com­mit­ment and found the poster no more attrac­tive than they had before select­ing it (see also Frey, 1981; Frey, Kumpf, Irle, & Gniech, 1984; Girard, 1968; Jeck­er, 1964). Inter­est­ing­ly, how­ev­er, par­tic­i­pants failed to pre­dict this dif­fer­ence and thought they would be equally happy whether they could exchange their poster or not.

  4. From “A Chance to Keep Up With New Tech­nol­ogy (for a Price)”, Stross 2011, New York Times:

    Pro­fes­sor Kalra was co-au­thor of a 2009 arti­cle pub­lished in the Jour­nal of Con­sumer Research that exam­ined pur­chase records from the elec­tron­ics depart­ment of an uniden­ti­fied retail­er. [Tao Chen, Ajay Kalra and Bao­hong Sun (2009), “Why do Con­sumers Buy Extended Ser­vice Con­tracts”, Jour­nal of Con­sumer Research Vol­ume 36 (De­cem­ber), 611-623] An extended ser­vice con­tract was bought in about 3 of every 10 trans­ac­tions.

  5. From Stross 2011:

    Mr. Fassler says Best Buy has not dis­closed for many years how much extended war­ranties con­tribute to its prof­its. Con­sumer elec­tron­ics retail­ing is “his­tor­i­cally a low-­mar­gin busi­ness that is depen­dent on extended war­ranties for prof­itabil­i­ty,” he says. “Per­haps extended war­ranties have become even more valu­able to Best Buy recent­ly, as its con­tent busi­ness­es—­like movies and music—have shrunk.”

    War­ranty Week pro­vides aggre­gate and bro­ken-­down fig­ures in “Extended War­ranty Admin­is­tra­tors: While auto and PC man­u­fac­tur­ers have the top spots, insur­ance com­pa­nies and third party admin­is­tra­tors grab the bulk of the pie”:

    Just as in pre­vi­ous edi­tions we’ve sized the prod­uct war­ranty indus­try to be in the neigh­bor­hood of $25 bil­lion per year, in this edi­tion we’re sug­gest­ing that extended war­ranties gen­er­ate in the vicin­ity of $15 bil­lion per year in pre­mi­ums paid. Not all that money goes to the actual admin­is­tra­tors and under­writ­ers of the poli­cies, how­ev­er. In fact, we’re esti­mat­ing that roughly half is kept by the actual sell­ers – the retail­ers and deal­ers in the world of war­ran­ty. Only $7.5 bil­lion passes through to the admin­is­tra­tors, we esti­mate.

    “The War­ranty Wind­fall” by R. Berner Busi­ness Week (2004), offers more details on house­hold names:

    War­ranties cost vir­tu­ally noth­ing to mar­ket, and the prod­ucts they insure rarely need repairs. Says FTN Mid­west Secu­ri­ties Corp. ana­lyst Daryl Boehringer: “It’s just pure profit flow­ing down to the bot­tom line.”

    Last year, prof­its from war­ranties accounted for all of Cir­cuit City’s oper­at­ing income and almost half of Best Buy’s, say ana­lysts. They fig­ure that profit mar­gins on con­tracts are between 50% and 60%. That’s nearly 18 times the mar­gin on the goods them­selves. For exam­ple, a four-year con­tract on a $3,000 flat-­panel TV costs about $400. Best Buy gives its insur­ers $160 and keeps $240 for itself.

    …As ser­vice con­tracts become more crit­i­cal to its bot­tom line, Best Buy has actu­ally cut back on dis­clo­sure. The Rich­field (Min­n.)-based chain does­n’t report its war­ranty prof­its sep­a­rate­ly, though it used to give the per­cent­age of sales that the con­tracts com­prised. It stopped doing that after fis­cal 2001 and buried the num­ber in a rev­enue cat­e­gory labeled “oth­er.” Then for fis­cal 2004 it stopped report­ing the “other” cat­e­gory alto­geth­er.

    Cir­cuit City is more forth­com­ing. The Rich­mond (Va.)-based out­fit reports how much rev­enue the con­tracts gen­er­ate, along with the per­cent­age of sales they make up – but not the profit they pro­duce. For the year ended Feb. 29, it said its war­ranty rev­enue totaled $326 mil­lion, or 3.3% of sales. Clear­ly, says SAFE’s Sebas­tian, the retail­ers “don’t want to dis­close to J.Q. Pub­lic how much money they are mak­ing on these con­tracts.”

    Using details gleaned from indus­try sources, though, ana­lyst Boehringer put together esti­mates of just how lucra­tive these con­tracts are. For the year ended Feb. 28, he esti­mates con­tract prof­its accounted for 45%, or $600 mil­lion, of Best Buy’s $1.3 bil­lion oper­at­ing prof­it. He fig­ures that with­out con­tract prof­its, Cir­cuit City would have posted an oper­at­ing loss from con­tin­u­ing oper­a­tions of $195 mil­lion last year instead of a $564,000 prof­it.

  6. See eg. Wikipedi­a’s sec­tion, Google for “best buy sucks”, the break-­down by cat­e­gory of com­plaints to the ; or you can just read For­tune Mag­a­zine’s “Best Buy’s giant gam­ble” arti­cle for your­self. (If you can read through this arti­cle with­out real­iz­ing that Best Buy admits that its cor­po­rate strat­egy is “charge suck­ers high prices”, then you need to work on your crit­i­cal think­ing skill­s.)↩︎

  7. Report­edly, Game Informer found a 54.2% break­age rate for Xbox 360s by sur­vey­ing read­ers; Exam­iner claims just <16.5% based on how many Xbox 360s are active online. Nei­ther fig­ure seems very reli­able.↩︎

  8. A sit­u­a­tion in which the insur­ance is obvi­ously prof­itable, as what would have been an $800 expen­di­ture becomes a $460 expen­di­ture—which saves a healthy $340.↩︎

  9. Chen et al 2009 note that Con­sumer Reports listed the over­all fail­ure rate of video game equip­ment at 9%.↩︎

  10. not a triv­ial con­sid­er­a­tion, given their cus­tomer ser­vice and the lengthy list of excluded issues↩︎

  11. From Stross 2011 (NYT):

    Mark Kotk­in, direc­tor of sur­vey research at , says, “The sales­per­son often tells you, ‘This will give you peace of mind in case you need an expen­sive repair. I would get it.’ But the odds of a prod­uct break­ing down dur­ing a typ­i­cal extended war­ranty period are low.” Even if the prod­uct does break, the cost of repair is not much more, on aver­age, than the cost of the war­ran­ty, he says. He con­cludes that extended war­ranties “are a bad bet.”

    Ajay Kalra, a mar­ket­ing pro­fes­sor at Rice Uni­ver­si­ty, agrees. “All the sta­tis­tics are com­pelling: in almost all cas­es, you should­n’t buy the extended war­ran­ty,” he says.

  12. Stross 2011.↩︎