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Hot spots for over-purchasing

Here are the types of insurance and protection products often over-purchased.

Appliance warranties: Usually the warranty cost will far outweigh the probability of your appliance failing. A decent washing machine should have a probability of failure of less than 1 percent. It's a waste of money. Yet a third of people buy it. What's more, research shows that if you feel you got a good deal on your appliance and love it you're more likely to buy the additional warranty rather than if you feel you just got an okay deal. "When you talk about insuring cell phones, TV's and computers and all the sudden you are paying $500-$1000 dollars a year to insure stuff, that really doesn't give you much value," says Weiss.

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Flight insurance: One study in Economics looked at people buying flight insurance and found the purchase to be irrational. First, it's overpriced. Second, flights aren't likely to crash. Besides, what's the difference between dying in a plane crash vs. dying some other way? Why would it make sense to buy insurance for one cause against another?

Rental car insurance: Most people are terrified of the message at the rental counter that they're on the hook for a $40,000 car. But most standard auto insurance policies cover rental cars, and so do credit card companies. To get your money's worth for rental car insurance, you'd have to total the car one out of every two rentals, explains Pauly. Check with your auto insurer to confirm coverage for rental cars, but even if you don't have protection, it's still a colossal waste of money from a probability standpoint, says Pauly.

Divorce insurance: In case "happily ever after" has limited duration, there's divorce insurance from SafeGuard Guaranty Corp. But if parting from your spouse is a real concern, you could set aside money in an emergency fund to have your own divorce cash.

Identity theft protection: Recent cyber attacks against banks and other businesses have left consumers skittish about protecting their personal information. After all, what if your personal account numbers were stolen this way? Many insurance companies offer insurance against identity theft. Most include credit monitoring, alerts on new activity and cash to cover expenses in the event of loss.

When it works as intended, insurance is an extraordinarily effective method of spreading risk among many people.

But more often the purchase of insurance is fraught with misunderstandings. While not having enough coverage can lead to financial ruin, purchasing too much insurance wastes money.

"Many people would say, 'How can you have too much insurance?'" says Mark Pauly, co-author along with Howard Kunreuther and Stacey McMorrow of Behavioral Economics.

Pauly says the answer is this: When you buy insurance as opposed to being uninsured and paying for the loss yourself, the insurance company ends up keeping some of your money so, on average, you'll end up spending more to have insurers pay for your loss than if you bore the cost yourself.

Insurance isn't a smart buy if it costs too much for the protection you're going to get. That's what's meant by "too much insurance."

Why we buy too much insurance

One reason people buy insurance that's not a good value for their money is a mistaken assumption about how likely it is that they'll make a claim. They overestimate the probability of collecting money.

Another reason: People like security. It makes them happy to feel protected.

"What's wrong with that?" asks Pauly, even though there are better ways to spend your money. "It's a taste for protection -- no matter what the cost."

If you like plenty of insurance, you probably hate deductibles. Whether it's your homeowners insurance, your auto collision coverage or your health insurance, people seem to want to avoid deductibles. Pauly explains this as "deductible aversion." Even though in many cases you can save on your premium by buying a higher deductible policy, people still opt out of the higher deductible.

Because you're not certain to have a loss, you'll end up paying out additional premium in order to avoid a larger deductible that you probably could have financed yourself.

"When someone comes to us with the lowest liability allowed in the state and they get into an accident, sometimes that won't even cover the damage to the other car," notes R.J. Weiss, a certified financial planner with Weiss Insurance Agencies in Wayne, Illinois.

In a study in the Journal of Economic Psychology, researchers found that people who didn't know much about insurance underestimate the cost benefits of a policy with a deductible. Study participants didn't want to buy deductible policies because they thought they were overpriced. However, they didn't take into account the slim chance of paying the deductible.

So what have we learned here?

The much more grievous error is to not buy essential insurance when you should have it, such as health, term life insurance, and disaster protection from floods and earthquakes.

"We think a much more serious failing of consumers in insurance markets is underinsurance not over-insurance," notes Pauly.

Weiss recommends first making sure you have enough coverage for essentials, and then cut back on extraneous policies.

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