Friday, December 7, 2007

Insuring irreplaceable assets

Last Wednesday night my computer wouldn’t start up. This is my only computer, the laptop where I keep all my work, and which I haven’t backed up in a while. Understandably, I rush to contact the manufacturer’s support service. Diagnostic: dead hard-drive, DNR. The first technician I speak with suggests that I try to restart the computer with a back-up copy of the operating system, which, he tells me, “would erase everything in the HD.”

A personal computer full of data is a perfect example of an irreplaceable asset. And when I say “irreplaceable” I don’t necessarily mean it in a literal way. Many of my files can be downloaded from the internet or reconstructed, and I can redo my writings. But I would be willing to pay a lot more money than anybody else for that “replaceable” stuff.

Every possession has a personal value (how much it is worth to its owner) and a market value (the price the object would fetch in a sale). They’re equal for assets that the owner can substitute readily in the market. But the personal value can be higher than the market value for objects to which the owner attaches unique attributes. Those are the assets I call “irreplaceable*.”

A classic example is bottles of wine. A 1995 Bordeaux can be purchased in a store now, say, for $60; yet many people who bought a bottle of the exact same wine back in 1995 would not sell it for less than $80.

Assets acquire owner-specific attributes in multiple ways. Sometimes it’s the way in which the owner took possession (family heirlooms); some other times it’s the memories accumulated through years of use (clothes), or the memories they bring back (pictures). But oftentimes the reasons are less sentimental. I value my hard-drive above its market price because it contains information specific to my work, and nobody else’s.

Just as in the case of any other worthy asset, risk-averse individuals would insure irreplaceable assets against loss. And the insured amounts would not be based just on their market value, but on their higher, personal value. Nothing special here. Irreplaceable objects become an interesting economics topic, however, if their loss can shift the utility that their owners derive from wealth. In economics parlance, when people display state-dependent preferences.

As an illustration, consider the case of wealth and parenthood. Parents face two states of the world: in state one the children die, in state two they live. Of course, parents are better off if the kids survive than if they die. But it’s also true that they derive greater utility from an extra dollar of wealth if their kids survive.

State-dependent preferences affect the demand for insurance of assets. If insurance is purchased, an individual foregoes some wealth (the insurance premium) in the good state and receives a certain sum (the insured amount) in the bad state. Because an extra dollar is worth less in the bad state than in the good one, insuring the asset whose loss triggers the bad state is not a good deal. In any case, the premiums and insured amounts are smaller if preferences are state-dependent.

Continuing with the example above, would you buy life insurance for your kids? Most parents don’t. They save themselves the life insurance premiums, which they can spend with their kids in the good state. If the children die, the parents don’t get any money. But the loss of a child puts parents in a state where they don’t get much of a kick out of spending money anyway.

To use an example from the recent news: many American families choose not to have health insurance. Many millions more have low insurance coverage. I don’t mean to play down asymmetric information issues, which can make high coverage unaffordable. But it makes sense that a sick person, who is limited in the range of goods and services that she can consume, gets less utility out of an extra dollar of income than her healthy self. One must seriously consider the possibility that the observed heterogeneity in health insurance coverage arises simply from differences in state-dependent preferences across people.

In civil court cases it’s common to give a monetary compensation to the victim. The practice is as unavoidable as it is inefficient. Let’s say that an individual breaks his femur at work and becomes permanently disabled. The court finds that the accident was caused by the employer’s negligence and grants damages of one million dollars: $750K for lost earnings and $250K for the physical pain and psychological suffering. The $250K may not produce much utility now that the victim can’t walk or drive. And yet, what other form of compensation can be provided? Would an apology be any better?

Investments in prevention are usually more efficient than insurance at protecting individuals in the case of state-dependent preferences. Installing fire-proof ceilings and clearing brush will protect a house in a forested area when the inevitable wildfire occurs. Colonoscopies can prevent the occurrence of the bad state itself (colon cancer). Backing up the content of your hard drive avoids disaster when the bad state strikes.

This morning I called a company specialized in hard-drive recovery. They’ve told me that because the hard drive didn’t suffer any physical damage they should be able to retrieve most, if not all, of my data – which is all I needed to hear to switch to a more pleasant state (of mind) in which to spend my day.

* In this as in the rest of this post I follow the seminal analysis of Philip Cook and Daniel Graham, published in 1977 in the Quarterly Journal of Economics.

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