We all want certainty. We want our investments to average 5% return a year (7.375% if you are in the state of California), our children to grow up strong and healthy and it to only rain at night. However, life is uncertain.
Insurance is about creating certainty. A small cost is paid, instead of a small chance at a large loss. Health insurance is part pre-paid services (check-ups) and part joining a purchasing cooperative (in-network pricing is a lot cheaper than out-of-network) and part real insurance. Car insurance doesn’t include oil changes, although they do control where certain repairs are made. Not just insurance companies make money on reducing uncertainty.
I once had a competitor that sold a tuning service for radios and electronics. This advantage was a significant part of his marketing and brand value. At some time in the past, there might have been some value in swapping out vacuum tubes but since the 1960s most marine electronics were solid state. By the 1990’s there was nothing to be done to a solid state radio, and if they didn’t work out of the box, they had to go back to the manufacturer. He sold fear, uncertainty and doubt or FUD.
FUD was made famous by IBM, who would meet every new competitor in the computer industry with comments about reliability, threats of the loss of warranty coverage, rumors of financial difficulty and vague hints about losing purchasing status. For the longest time I’d hear the comment “no one got fired for buying IBM”. FUD works.
People will pay for security – even if the math suggests it is a bad bet. My firm started selling extended warranties on our products. This was a big money maker for Circuit City as electronics extended warranties had a 90-95% margin. For a while the staff wouldn’t sell them, they thought the extended warranties were a rip-off of the customers, and we had a no-hassle money back guarantee. Buying an extended warranty is not a good bet, but people appreciated the certainty and paid for it.
Eating at McDonald’s is not normally a “treat”. We select fast food because of the consistent product, price and convenience. We know what we are getting – uncertainty is reduced. Retailers who reduce uncertainty increase sales. Zappo’s can sell you shoes because they agree to take all returns. I doubt Zappo’s makes much profit on its shoes, the freight has to be killing them (see here) but given that Amazon owns them and Amazon is the worlds largest capital destroyer it is ok.
I see the problems with seeking certainty as a function of information asymmetry, competition and add-ons. The retailer that offers a money back guarantee knows how often goods are returned and when they sell you an extended warranty, the likelihood of your using the warranty. You can’t judge if it is a good deal or not. Those situations are referred to as information asymmetry, where one side knows more than the other. Learning more about failure rates can give you confidence to skip paying an extra 15% for a product, knowing the chance of fault might be 0.02%. A phone with a one year warranty and a three year overall life doesn’t present much time for a failure.
Your car insurance company knows more than you do about the likeliness of an accident and they price the insurance so that they make a profit. The car insurance company is kept honest by a competitive market place and regulators. Competitors push prices towards an equilibrium, which is lower in price than an un-competitive market.
The least competitive market is one where you have little time and no access to competitive prices or data about risk. This happens while standing in line, or in the midst of a transaction when an add-on is offered. Rental car companies are good at offering you several levels of insurance-like services (one full priced for 100% coverage, a second with a deductible, a third with a collision damage waiver) while all levels of coverage are priced extremely high. It is not unusual to pay $5-6 a day for coverage for your new car, and $40 a day for insurance for a rental car. The extended warranty is pitched to you at the register without any time to calculate the costs, benefits or risks.
Seeking security isn’t a problem, and reducing uncertainty isn’t bad. One consequence of a population that doesn’t understand probability is that we will be taken advantage of by providers of certainty. Be a smart consumer, do your research before you buy.
***
Dr. John Zott is the principal consultant at Bates Creek Research & Consulting.
I am the chair of the Careers Committee at FEI Silicon Valley, a senior adjunct professor at Golden Gate University and I comment regularly on issues that affect growth businesses. If you are looking for a CFO for your consumer company, or are a former student, colleague or would just like to connect – reach out.