Defining a Discount

For the past month or so, I have been thinking about the overuse of the word “discount” in our national consumer consciousness. Everywhere you turn – whether on television, in print, or on the Internet – businesses tout the discounts you can realize by purchasing their product or buying your merchandise in their store. American consumers love a bargain, and buying a product at a “discount” is something they not only relish, it is something they have come to expect. The unfortunate side effect of this “discount” mentality is the waning of value: purchasing quality products or services at a fair price.

This “discount” mentality was brought home to me not long ago when I watched a television ad for an insurance company. This particular ad features a female sales clerk in a fictional shop selling insurance services to a customer. She asks the customer a series of questions like, “Will you be buying your homeowner’s insurance with us?” or “Will you be purchasing on line?” and, when he responds to each question with an affirmative, she joyfully exclaims, “Discount!”

So is the consumer in this advertisement really receiving “discounts?”

If you answered this question with a “No” then you are a well-educated consumer. Insurance companies – like every company – are in the business of making money, and toward that goal they employ a large number of math-junkies who calculate out things like actuarial tables. These tables take into account everything from a consumer’s age to where they live to their past insurance history, etc. This helps them define the risk they are likely to assume when they sell insurance to a customer. The lower the risk, the less likely it is that they will ever have to payout more than a customer will pay them for their insurance.

When you combine insurance services through the same company you will be making two payments to the insurance company. Now they have two revenue streams from the same customer, but the insurance company has now assumed two separate sets of risk. Interestingly, however, these two sets of risk do not mean that the cost to the consumer is the combined cost of the separate insurance policies, nor does it mean that the risk to the insurance company is the same as the combined risk of each policy.

Think of it this way: when an insurance company provides you any type of coverage they are also making a calculated wager that they will make more money than they will have to pay out in claims to you over the course of your coverage. So when they provide auto insurance to you they may calculate that the chance they will have to make a payment on your coverage is the same as rolling an 11 at a craps table (a 1 in 36 chance). From a probability standpoint, this means that for every 36 people they insure, they will only have to payout an average of once. They will then calculate the cost of that average payout against the revenue they can receive from 36 insured customers to come up with a policy price that provides their targeted profit margin while covering all the associated costs with providing that coverage.

When you purchase homeowner’s insurance, the same rules apply. The insurance company again calculates the chance that they will have to pay out a claim on your policy. In this instance they determine that the chance they will have to pay a claim is the same as you randomly picking the ace of spades from a shuffled deck of cards (a 1 in 52 chance). This means that for every 52 policies they sell they will, on average, only have to payout once. And, once again, the cost of these policies is calculated to cover the cost of the policy and the targeted profit margin.

But let’s say, you purchase your auto insurance and your homeowner’s insurance from the same company. In our examples above, the risk to the insurance agency in providing you auto insurance was 1 in 36 and the risk in providing homeowner’s insurance was 1 in 52. But because you have both policies the risk to the insurance company has actually decreased – by a substantial amount.

Now the chance that the insurance company will have to pay you a claim on both policies is 1 in 1,872 (1/36 times 1/52). But where this becomes really interesting is when you calculate the likelihood of the insurance company having to pay a claim on either one of the two policies. The math is a little more involved here so trust me when I tell you that the chance the insurance company will have to pay you on either your auto policy or your homeowner’s policy is roughly 3 in 100.

Of course, all of the above examples are a gross oversimplification of what insurance companies actually do, and all the numbers I present are purely hypothetical and therefore don’t represent any true odds or risks. However, this exercise does demonstrate that the risk insurance companies incur from selling you multiple policies decreases, and therefore they are able to charge less for bundled policies.

So the question is this: does the reduced price of multiple policies from the same insurance company when compared the cost of an individual policy actually represent a “discount?” The answer is no. A discount is a reduced price from a predetermined, commonly accepted price. The prices of insurance policies are all predetermined by an expansive set of criteria calculated by the insurance company that are guaranteed to cover their costs while achieving their targeted profit. A reduced risk to the insurance company means a lower cost to the customer. Thus the cost of the insurance policies are nothing more than the cost of the policies and are never “discounted” in the true sense of the word.

Nonetheless, the American consumer’s love affair with “discounts” and bargain hunting lead many insurers to toss the “discount” word around in their advertising and promotion to attract new customers. And yet, the only thing any consumer really needs or wants in insurance is the best possible coverage they can afford. And therefore your best option is to find a local insurance agent you trust to help you find the best coverage at the best price.

Next week: What “Storewide Sales” really cost a retailer.