Warranties and insurance companies like to play the game of probability. They are essentially gambling that you will not need to be covered, or that the cost of coverage will be small compared to what you paid for it. That is how they make money. When you buy insurance you are looking for security. You know that there is a chance that your car will break down so you buy an extended car warranty. You know that there is a chance that you could get sick or hurt, so you buy health insurance. Your house could be damaged in a flood, hurricane or earth quake, so you buy insurance for that. You pay to know that in the event that something bad happens, you will be compensated or taken care of. Although chances are probably greater that something bad won't happen (or insurance companies wouldn't stay in business) it's better to be safe than sorry.
Insurance companies must remain aware of the degree of likelihood that you will get into a car accident, that your house will be hit by a hurricane, or that you will get severely ill. They can't know for sure but they can make a pretty educated guess, going by past statistics and statistical trends. Once they know how risky you are to insure, they charge you accordingly. If you are likely to be hit by a hurricane, need a quadruple bypass surgery, or get into a car accident, they will charge you more. Conversely, if they see you as a healthy, careful person, you will be charged less.
You pay a premium to insurance companies in exchange for security. If you have the appropriate insurance and are faced with an unexpected expense, you will be taken care of. This is very appealing to people who are averse to risk. However, some people do not want to pay a premium. They take a gamble by not buying insurance. There is the possibility they will make it through year after year without incident in which case, they have come out ahead. However there is also the possibility that they will be faced with a substantial unexpected disaster in which case, their gamble could cost them dearly.
The same general concepts apply to buying an extended car warranty. You and the entity giving you the warranty must look at the car and decide how probable it is that there is going to be a problem with the vehicle. And, if they think there is going to be a problem, they need to predict how much it will cost. A little math, a premium and voila, you have an extended car warranty. The driver must essentially do the same thing. If you are buying a car that should run well for years to come and would not cost a lot to fix, then you should not be willing to pay very much for an extended car warranty – chances are good that you would save money by not getting one. However, if you are a worrier and are afraid of the risk, you may be willing to pay a little extra for your warranty.
With all of that said, you should also know that the dealers and companies selling warranties are making a lot of money. Lucy Lazarony, an authority on extended warranties says, “For most people, the average repair claims against a $1,000 extended service contract come to about $150.” This means that the people selling the warranties are doing a very good job predicting the quality of cars and capitalizing on peoples risk aversion.
To throw another wrench in things, warranties are also a great indicator of the quality of a car. If a car dealer is willing to sell you a car at a competitive price and give you a good deal on a warranty, they expect that it will not have any problems. In other words, it is a good car. This conclusion and its implications were enough to earn three economists a Nobel Prize. Although, in my opinion, this information doesn't make the decision much easier, it does give you some insight into the forces at work.
By David Wade