A Ramble on Gambling vs. Insurance - and a Fun Quiz

There was a throwaway line in my post about Farecast that I’ve been thinking about ever since I hit “publish”. “It” being FareGuard (the Farecast product that is the subject of the post), I said:

Frankly, I’m surprised it’s not illegal (since it effectively is similar to gambling or an unregulated derivative security).

Setting aside the fact that I probably shouldn’t say such things so flippantly about other people’s businesses - I assume they did their legal homework - something about it has been bothering me.

It got me thinking about all the different kinds “bets” you can take against the future in one form or other — and wondering why some of them are legal and others aren’t. Personally, I think it’s stupid that a country’s worth of adults with access to compulsory free education can’t gamble on anything they damn well please, but the state of the social contract is such that there’s a political consensus otherwise, and I’m interested in some of the contradictions.  My full ramble (and quiz) is after the jump.

You can look at these bets categorically.

First, there are bets that convey actual value. When you buy stock in a company like Yahoo!, you are betting that the net present value of the income of the company will go up at a faster rate than other stocks. But, you are also buying a piece of equity that conveys all kinds of ownership rights, like voting, dividends, and the right to participate in splits and liquidation events. The SEC regulates the issuers and markets of publicly traded equity closely, and you sign a lot of disclosures on the risks of investing when you open a brokerage account. So reasonable people generally agree it’s acceptable to make this market open to little old ladies in the Midwest.

When you get to riskier securities, like derivatives and commodities, you’re talking about bets that are one level of remove from ownership, but they remain tied to hard assets (someone writes every call you buy and is on the hook if you exercise), and you get even scarier disclosures. Angel investments (still tied to hard assets but less publicly scrutinized and regulated ones) are limited only to accredited investors (with yet more disclosures). This all works for me.

Then there’s a whole category of things like extended warrantees on products. This strikes me as an absolute, absurd gamble of a betting proposition: is my tv going to crash in more than one year (the free warrantee period) but less than 3, with the price of repair being more than the total cost of the warrantee + shipping?

One reply is to say, hey, it’s not gambling, you’re simply paying the manufacturer for a little extra service on top of what they’re giving you, which you hopefully won’t need. Sort of like having an unlimited rate plan on your cell phone when you may or may not use the minutes. Buy this tv with a one-year warrantee for $300, or buy that one with a 3-year warrantee for $375, right?

But this doesn’t stand up to scrutiny. Many of the issuers of these plans are retailers, not the actual manufacturers, and some are pure aftermarket 3rd-party. Plenty of the insurers don’t even do the repairs themselves, simply reimbursing for covered repairs. So let’s get this straight: a retailer can sell you on a tv, then with a straight face can sell you a ticket you can cash in only if your tv blows up, knowing full well that this is a money-loser for 9 out of 10 people. They get to use inside information about the failure rate and are not obligated to disclose it, and they get set the price and put enough of a house “vig” on it to make it a profit center. (Meaning, all 10 buyers are paying more than the true “expected” value of the ticket - and if you think about it, retailers are already protected on the downside anyway, since they would presumably go after the manufacturer in the event of any unreasonably high repair rate.) Finally, on top of that, they get to put hard-sell tactics around it that would make a timeshare salesman blush.

What? Will someone please tell me exactly how this is different from a bet on a single number on the roulette wheel. In fact, it’s worse; in casinos, odds and payouts are disclosed, and they don’t let teenagers in.

For anyone who thinks this is small potatoes, by the way, simple math says that if every household in America on average buys one of these policies a year at $50, that’s a five-billion-dollar bet that the house will always win. But I’m guessing Circuit City stores aren’t all located on indian reservations, subject to gambling board oversight, or paying vice taxes.

And yet if I were an educated investor and wanted to bet against iPhone hardware quality, I couldn’t put $100,000 to work against future repair reimbursements (not without buying a couple thousand iPhones anyway), nor could I legally write those tickets if I thought they would have unexpectedly high performance. (Or could I?)

Life insurance is no different that I can see. You’re taking a bet, essentially that you will live short enough that the NPV of the payout minus the premiums is positive. Okay, well, insurance is a regulated industry, so let’s assume the gouge is capped, and given that life insurance is often used to provide for someone who might not otherwise be able to provide for himself, there’s a reasonable social safety net concept that makes sense here. Similarly, you can make an argument that car insurance is a hybrid of health insurance and distributed taxation, but enough.

Now wait. It turns out that, if you are an employer, you can take “key man” or even so-called “janitor’s insurance” to bet against the future protect shareholder value. This strikes me as a concept you’re glad to have as an investor in, say, Oracle. Plus, hey, life insurance on third parties!

So can I walk into a bookie’s State Farm and put $1000 on Lindsay Lohan to die before the age of 50? (Only if I’m her employer, and it would take a lot more than insurance to get me to do that.) Can I “write” insurance on myself - I’d happily sell you a fat payout policy on me dying before I’m 50, for the right premium.

I could go on: travel insurance, postal insurance, or even lifetime Tivo memberships for that matter.

But for now back to Farecast. You know I love the product, and I’m just having some fun here, so you tell me. Is Fare Guard:

• a): simply a guarantee on merchandise - i.e., a premium information service guaranteeing the validity of its information up the to limit of damages due to its information being wrong (in which case please tell me why I can’t start a similar information service on baseball outcomes);
• b): an insurance policy;
• c): a casino-worthy prop bet?

posted on Friday, February 2nd, 2007 at 5:45 pm Category: business models. Comment or trackback.