Economists Do It With Models

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All I Need To Know About Economics I Learned From Perez Hilton, Tiger Woods Edition…

February 2nd, 2010 · 2 Comments
Econ 101 · Markets

Yes, I have a lot of feeds in my Google Reader, and yes, Perez Hilton is one of them. Sometimes I just really need to know who has new plastic surgery or what Lady Gaga had for breakfast, ok? (Before you go knocking on Ms. Gaga, I would like to point out that, aside from the eccentricity and electronica and whatnot, she is very talented.) On the breakfast and plastic surgery fronts, Perez never fails to deliver, and sometimes he even offers some unexpected pleasant (read, useful) surprises, such as this one:

Companies Getting “Tiger Insurance”

Not a bad idea!

Companies with celebrity endorsers are now taking out insurance based on the Tiger Woods scandal to protect them from potential losses! Lawyer Brian Socolaw explains:

“Companies are saying if it could happen to Tiger Woods, it could happen to anyone. … For some companies, it’s a tremendous investment, and when it goes bad, it is not only the loss of investment, it’s a black eye for the company.”

These companies are also placing new morals causes into effect in the celebrities’ contracts that give them the right to terminate endorsement deals if the celebs get into any mayjah trouble!

Way to set the precedent, Tiger!

I was going to send this to Tyler Cowen and Alex Tabarrok over at Marginal Revolution for their “Markets in Everything” section, but then I figured why let them have all the fun?

One of the positive features of capitalism is that when a market need is identified, companies usually find that profit opportunity and fill the market need. In this case, the need is for companies to hedge their bets and cover their butts in the case that their highly-paid celebrity endorsers go rogue (ha) and behave in ways that tarnish the image of the companies that they are supposed to make look good. From an economic standpoint, this makes perfect sense, since the bad behavior of the endorsers has a negative financial impact on the company in a number of ways. The most direct financial consequence is that the company probably no longer wants to use the ads that it created with the celebrity, and it has to pay for a new ad campaign and celebrity. Just this replacement cost can run in the millions of dollars. Furthermore, the company potentially suffers a loss in terms of tarnished image and whatnot that could be reflected in sales figures, stock price, etc. In the case of Tiger Woods, economists estimate his negative impact on the market value of his sponsors at $12 billion. I am not convinced that that hit will persist in the long term, but it’s certainly something that sounds appealing to insure against.

The market for insurance arises because people, companies, etc. are risk-averse in a lot of situations. To test whether you are risk averse, consider the following question: Would you rather have a guaranteed $50 or a 50/50 shot at $100? If you want the $50, you are risk averse. (If you specifically want the 50/50 shot, you are risk-loving, and if you don’t care one way or the other you are risk-neutral…or just too lazy to think about the question.) If you are risk-averse, then, you would be willing to pay a sum of money, let’s call it a premium, to have the guaranteed $50 rather than the uncertain outcome.

This is exactly how insurance works. People and companies pay a premium to transfer risk from themselves to the insurance company. Why is the insurance company willing to take on this risk? The important part to remember is that the insurance companies (hopefully) have more than one customer. The individuals and companies that are seeking insurance are risk-averse because they are facing a small number of large-consequence uncertain outcomes- you can basically think of them as not being very diversified in their risk. (To put this in perspective, consider that it makes a lot more sense to insure one diamond ring than it would to insure the myriad random household appliances you have lying around, even if they have the same total value. The reason that this is is because you only have two outcomes with the ring – “lost” or “not lost” – whereas with the appliances the risk is spread over a large number of unrelated items.) The insurance company, on the other hand, is well-diversified because it is taking on a number of different customers. To continue the analogy, the individual customers are like the household applicances- what is the chance that all of the appliances are going to fail at once? (I mean, there are only so many homewreckers to go around.) Because of this diversification, the insurance companies can act in a roughly risk-neutral way and thus (at least on average) profit off of its customers.

Accenture would likely be willing to pay a hefty premium to insure itself against Tiger Woods’ man parts and their bad habits, since they only employ one Tiger Woods and he is a large part of their budget. If insurance companies could make a lot of these deals, they would be willing to offer such a product at a price that would be acceptable to Accenture. And a market is born.

Lest you think that this idea is entirely novel, keep in mind that insurance has been crucial to the entertainment industry for a long time now. (That Slate article is excellent, and you really should read it.) Studios have to insure against anything happening to their stars (including them being, well, flaky celebrities) that would prevent completion of a movie and/or make the studio look bad. I am now mainly curious about how actuaries put a dollar figure on a wandering eye. You can read a little about that in the article here.

Tags: Econ 101 · Markets

2 responses so far ↓

  • 1 Scott // Feb 4, 2010 at 12:21 pm

    Right, but the market for this type of insurance would be quite small and very difficult to calculate. I’m remembering insurance policies that covered a tap dancers legs and someone else’s smile. But a reputation is pretty intangible.

    The $12B study looked at how a select group of companies fared after the Tiger aftermath hit the newsstands. The author looked at the firms that had marketing agreements with Tiger performed, but he didn’t baseline it against the market as a whole, against the firms’ direct competitors, or even against firms that had other spokesmen for their products. As well, he only looked at stockmarket data and not actual sales. Plus the stock market data he did use was a small timeline (ie a week or so), which once the Tiger story got off the front page, let some of the prices recover.

    Besides, it’s not new that there are ‘morals and standards’ clauses. Think Latrell Spreewell, Donte Stallworth, or even Gilbert Arenas. However, I’d think more advertising/endorsement contracts should become self-insured. Have an upfront payment and/or a cash-stream set up with some money held in escrow for the duration of the sponsorship. If everyone’s happy at the end, the money is released.

  • 2 Weakonomics Links: Where Your Taxes Go Edition | Weakonomi¢s // Feb 5, 2010 at 10:33 am

    […] Economists Do It With Models introduces us to a new kind of insurnace. I’ve said before that you can insure anything. This helps prove my point. Companies are now buying what’s called “Tiger Insurance”. No it isn’t protection from tigers, it’s protection from endorsers going crazy and tainting the company’s brand. Sounds crazy, but I’d be interested if Tiger was endorsing Weakonomics. […]

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