The Hidden Implications of a Larger Home Insurance Deductible

There are some hidden implications of a larger home insurance deductible. In June 2012 Forbes published an article titled The Smartest Homeowners Insurance Move: a $100,000 Deductible! Forbes is one of the top financial magazines, but in my opinion, using a high deductible is neither “smart” nor cost-effective . . . or even prudent.

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Those with limited personal assets can’t take the risk of financial failure; and those with a large net worth would not receive adequate return for their expenditure, in most instances.

The article suggested that when you choose a deductible you’re picking a number you’re willing to spend out of your pocket if you suffer a loss.

This article obviously isn’t directed toward the person with a home worth less than $200,000 or those with a renter’s insurance policy. However, a Google search for save money on home insurance by using a deductible, located dozens of personal finance articles advising the average person to use high deductibles.

In 2011, according to a report by Pitney Bowes, the average savings account balance in United States was $5,753. Obviously, even a $10,000 deductible would cause major stress to the average person’s personal finances.

How to Evaluate a Deductible Savings

I’ve been in the insurance industry for five decades and have heard the numbers. Although I don’t have proof, the rule of thumb I’ve gone by for years is that when you multiply the savings generated by changing your deductible by a factor of 2.5 it should be equal to less than the change in your deductible.

home-insurance-deductible-2.5-ruleSo . . . if you change your homeowner’s deductible from $500 to $2,500 the amount saved should be about $800 annually. Individual tolerance for risk comes into play, but the 2.5 factor gives you a place to start.

When I started in the insurance business most homeowner’s policies didn’t have deductibles. If an insured used their policy for home maintenance, the underwriter might have responded by placing a $100 deductible on their policy. In the 70’s and 80’s insurance companies recognized that the cost to handle small claims is exorbitant and almost all policies were endorsed to include a $100 deductible.

It goes without saying that insurance companies make their money by selling insurance. The more they sell the more money they make, because their rates and underwriting criteria are promulgated to make an underwriting profit.

If the insurance company can keep the total of claims and claims handling expense and the acquisition and underwriting expense to under 92.5% of the homeowner’s premium they have a good chance of providing an Return Of Investment of 12% to their shareholders, which is usually their goal.

You might also be interested in reading about car insurance deductibles.

Implications of a Reduced Insurance Premium

When insurance companies elect to sell you a reduced premium by also reducing your coverage (which they are doing with a deductible), you’re probably very foolish to bet against their actuaries.

So why are most of the personal financial experts suggesting higher deductibles?

The simple answer is . . . because sometimes it is the best alternative amongst several bad choices.

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I have served on numerous agents’ advisory councils for insurance companies. During the last several years I’ve attended a number of meetings in which we were asked how to handle the challenges of the current homeowner’s market. The question often posed to us by the insurance companies has been . . . what is more important to the insurance buyer . . . low price or adequate coverage?

Over the years, advertising by many insurance companies have taught the public that the purpose of insurance is to put you back in exactly the same position you enjoyed before your loss. In fact, one of the largest insurance companies ran a series of ads in which they reversed the film so that the ad started after the accident was over and ran backward to a point in time before the accident.

The Practicality of Insurance

Actually, the purpose of insurance is to leverage the law of large numbers by using amassed capital to make profits by fulfilling the average consumer’s “reasonable assumptions”.

It has been my experience that most people are quite reasonable when it comes to claims handling. They don’t expect miracles. They’re not looking to make a profit from their unfortunate event. They simply want their insurance policy to respond to protect them from financial disaster.

Given how little personal savings the average person in the United States has, financial disaster can result from the loss of a fairly small amount.

So… Why The Push to Higher Deductibles?

Maybe people are making that choice because it is decidedly better than reducing coverage in other areas that could result in much larger personal loss.

For example, some insurance companies have changed the coverage on roofs from Replacement Cost to Actual Cash Value. A Replacement Cost policy covers your loss without regard for depreciation. An Actual Cash Value policy will pay your loss according to the depreciated value of your roof at time of loss.

If your roof is 20 years old, it is quite possible the depreciated value could be as little as 20% of the replacement cost, especially if your shingles are 25-year composition shingles. If you have a severe hailstorm and your roof needs to be replaced under an Actual Cash Value policy you would receive 20% of the replacement cost.

Or, if your roof costs $15,000 to replace, you would receive $3,000 less your policy deductible. Under a Replacement Cost policy you would receive $15,000 less your policy deductible. That is $12,000 difference because of a policy condition. Many insureds would find a sudden $12,000 economic loss “unreasonable” and would incur a personal financial disaster in making up the difference out of their household budget.

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In my opinion, changing the coverage from Replacement Cost to Actual Cash value puts the insurance policy in jeopardy of falling outside the ability to fulfill the average insured’s “reasonable assumptions”.

However, The Insurance Industry Has To Do Something!

According to the Insurance Information Institute, in the years from 2000 to 2010 the amount of insured catastrophic loss in United States more than doubled (117% increase) over the previous 10 years.

When insurance companies suffer losses those losses are passed through to the consumer in the form of rate increases. Most of the catastrophic loss in United States during that decade was felt in the property area from windstorm. Subsequently the average premium for a homeowner’s policy in the United States increased drastically in the 10 years from 2000 to 2010.

According to the Insurance Information Institute, the average auto premium paid in the United States in the year 2000 was $690. By the year 2010 that premium had risen 17% to an average of $808 per personal lines auto policy.

In stark contrast, the average premium for a homeowner’s policy in the United States had grown 97% during that same period from an average of $508 to an average of $1,004.

Consumers have responded to this price increase in a variety of ways. Shopping has intensified and so has their review of their policy’s coverage.

Insurance companies who have increased price rather than reducing coverage have suffered a loss in market share. This might be largely due to the effort by several insurance companies to make insurance contracts seem like a commodity.

About 30% of the buyers of personal lines insurance will actively shop their insurance this year. That 30% of the market is the least loyal, most price sensitive part of the insurance buying public, according a McKinsey report earlier this year (2013).3

Because the auto insurance industry spends billions of dollars annually pursuing this 30%, the insurance buying public is subjected to a distorted view. That advertising wrongly teaches that insurance is a commodity that should be judged solely on its price.

Ironically, neither of the two most ubiquitous advertisers in the insurance industry, Progressive and GEICO, seems eager to write homeowner’s insurance, at least not in my state . . . Minnesota.

I just tried to get a quote for home insurance from both the Progressive and GEICO sites. The Progressive website quote was actually for a policy from Travelers, while the GEICO site provided a quote from a company called IDS Property Casualty.

Unfortunately, in response to the constant advertising that makes insurance seem like a commodity (that can be easily purchased in a box off a store shelf), many homeowners have reduced their homeowner’s policy premium by drastically increasing their insurance deductible. In most instances, that was a poor economic decision.

Insurance buyers were likely to have made this decision based on one of the following reasons:

  1. The chance of having a loss is remote.
  2. If I have a loss that isn’t covered by insurance I can deduct it on my income tax.
  3. If I have a large loss the contractor I hire to fix my house will build the cost of the deductible into the amount of loss and the insurance company will pay it.
  4. I might as well have a large deductible on my home insurance policy because if I turn in even a small claim the insurance company will increase my premium and in the end I will be the economic loser.

The Chance of Having A Loss Is Remote

Trent Hamm, in his blog, The Simple Dollar, stated that homeowners have a claim once every nine years.

It has been my experience that this number is set by most at somewhere between once every eight to twelve years. I’m sure that there are communities where the idea of a windstorm loss that is large enough to turn in an insurance claim is unthinkable. There are other cities, like Moore, Oklahoma, where frequency of loss has been chronicled.

The chance of having a total loss is remote in that only about one out of every thirty losses is a total. Combine that with the average person having a loss about once every ten years and your chances of having a total loss in your lifetime is about one in six. That might seem remote to some, but quite eminent to others.

Your mortgage agreement is probably silent on the amount of your deductible, but it is inevitable, if the current trend toward higher deductible continues, that mortgage companies will weigh in. It is logical that since they currently demand that you carry 100% of the value of your home for coverage (or amount of mortgage) that they would want you to have a deductible that you could easily cover. They do not want the value of the property to be impaired.

It is quite possible, should the trend to higher deductibles continue, that you would be forced to escrow a certain amount to fund the loss due to deductible.

I Can Deduct the Uninsured Loss on My Income Tax

According to the IRS, “Generally you may deduct casualty and theft losses relating to your home household items and vehicles on your federal income tax return. You may not deduct casualty and theft losses covered by insurance, unless you file a timely claim for reimbursement, and you reduce the loss by the amount of any reimbursement or expected reimbursement.”

You should be aware that there are many restrictions on these deductions including that you must subtract 10% of your adjusted gross income from any loss you deduct.

I’m not a tax attorney and you should contact a professional for sound tax advice. However, it would appear you can deduct the amount of loss from income, but that means you’re only recovering a percentage of your loss through this method. . .from 15% to 45% depending heavily on tax bracket.

The Contractor Will Build the Amount of My Deductible into My Loss

Chris Tulp, the owner of Premier Roofing company in Denver, Colorado, says it’s illegal to siphon money from an insurance claim to the homeowner. He goes on to say that this practice is technically a breach of contract between the insured and insurer regardless of whether it was facilitated by a contractor.

If an unethical contractor is willing to break the law in this regard, or place you in jeopardy of a breach of contract, isn’t it logical to assume they will also use cheap, unskilled labor and shoddy materials?

If I Turn in Small Claims I Will Lose My Insurance, So I Might as Well Have a High Deductible

Some personal finance advisors advise high deductibles because insurance companies will increase your premium if you turn in a claim. While this is probably good advise, I wonder if these advisers are taking into consideration that you have deductibles for both your auto and your home.

If you have a $1,000 all-other-perils deductible on your auto policy and a $2,500 deductible on your home insurance policy you could be looking at a total of $3,500 of deductible for a hailstorm loss. Some insurance companies will only charge one deductible if you have both your auto and home with them through a process often called “bundling”.

Insurance companies are looking for responsible people who have less then the average number of claims. Therefore, if you turn in a claim more often than every ten years or so, you are less desirable than the average customer. Insurance companies have the right to cancel your policy for claim frequency, and your loss history will follow you from company to company.

Insurance company share loss data through a process called C.L.U.E., which is the Comprehensive Loss Underwriting Exchange. Under this process they are able to find out information about you that includes: date of loss, loss type, and amount paid, along with general information such as policy numbers, claim numbers, and insurance company name.

It is prudent to only use your insurance when it is really needed because frequency of loss is as important as severity to the underwriter. Many companies in my state (Minnesota) will cancel a policy for two or more weather-related claims in a three-year period regardless of the size of the claim.

In conclusion, if you have a large home with a value in excess of $750,000 it might make sense to have a larger deductible in excess of $2,500. For the average home it doesn’t seem to be prudent.

For example, the Kiplinger letter of July 30, 2013 spoke about home deductibles and gave the example of a policy written by a large insurance company. It said that given a policy with $1000 deductible and a $3,000 annual premium you could save 24% by boosting your deductible to $2,500. It went on to say that you would save 37% by raising the deductible to $5,000, 47% by raising it to $10,000, and 53% by raising it to $25,000.

Using the rule of thumb that suggests that the savings generated when multiplied by 2.5 should be more than the amount of increase in deductible the only one of these options that makes economic sense is a raise from $1,000 to $2,500.

There is nothing magic about the rule of thumb I learned forty years ago. Everyone’s risk tolerance is different, but rules of thumb become widely held for a reason.

Finally, don’t be lulled by a percentage deductible. Several companies have gone to a 1% or 2% windstorm deductible, which sound innocuous. But if the value of your home is $300,000, your deductible at 1% is $3,000 and at 2% is $6,000.

Other Enhance Insurance articles related to “special” Home Insurance:

Do I Need Car Insurance or Home Insurance for My RV

Does Home Insurance = Dorm Insurance

How Do I Insure My Second Home

Mobile Home Insurance

Tiny Houses Can Be Insured

Enhanced Insurance is not written by attorneys. If you’re looking for legal advice, you need to contact a lawyer. Further, insurance practices and forms change constantly and are varied from state to state. For definitive answers in your area, contact a local agent.

While the majority of people want an agent involved in their purchase of insurance, many people want to see if they can save money by buying direct from the insurance company. Others want to try a direct quote to make sure the premium they’re now paying through their local agent is fair. If you want a quote for your coverage, click on the competitive quote button on the right side of this page.

Jim operates an insurance agent network called Insurance Partners, aggregating agents in the Midwest for over 25 years. He was National Agent of the Year for Metropolitan in 1993 and Midwest Agent of the Year for Travelers in 2011. He served as a founding board member of the Surplus Lines Association of Minnesota.

7 comments on “The Hidden Implications of a Larger Home Insurance Deductible

  1. Someone making a living off of insurance disagrees with low deductibles. Shocking.

    What is the point of using the average Americans savings account balance in responding to an article on Forbes? Wouldn’t the average balance of a Forbes reader make more sense? Do you think multi-million dollar home owners have $5753 in their savings accounts?

    You’ve stated “using a high deductible isn’t prudent”. But what is high? It appears that you think the average home owner is incapable of doing some simple math/risk calculation and making an intelligent decision.

    Jim, an article on the subject of the subject of determining deductible is an article targeted to consumers. Given that, I find it interesting you’d make this statement:

    “The purpose of insurance is to leverage the law of large numbers by using amassed capital to make profits”

    Well, then the lower the deductible the better!

    Btw, in 30 years of home ownership, I’ve had exactly ZERO insurance claims.

    • I disagree with HIGH deductibles for most people. The savings generated will not justify the deductible. I live in a prosperous community with many, many homes valued in the $millions. I also know that a shockingly high percentage of my neighbors are living paycheck to paycheck, and a good share of them read Forbes.

      If I didn’t think they were capable of doing a simple math calculation why would have I provided the formula?

      The fact that you have never experienced a homeowners claim isn’t evidence of anything other than your good fortune and maybe better than average maintenance and housekeeping. The insurance industry has lost a great deal of money lately on homeowner’s business. Your experience is far from typical.

      • Jim,

        I noticed you really didn’t address the points made by DSailer other than to say his zero-claim experience is atypical (which is probably true). Let me ask you another way then.

        Can you please explain your BASIS and REASONING behind your “rule of thumb”? Because it is not of any validity whatsoever if its based on nothing more than “what you have been doing for years”. No offense, but as has been pointed out you have you own set of biases too and, like with DSailer, your past experiences may be just as atypical.

        Thank you.

        • I’m at a loss as to what points I didn’t address, Michael.

          Why would you question my stating a “rule of thumb” that has been around since at least 1971 when I first learned about it in a management trainee course from my first employer, the Continental Insurance Company? A rule of thumb is “a principle with broad application that is not intended to be strictly accurate or reliable for every situation” (according to Wikipedia).

          By the way . . . “atypical” hardly applies to a 45-year career. The essence of insurance is finding homogeneous risks so that results ARE typical.

          I stand by my blog.

          Jim

          • In your rule of thumb formula, you advised multiplying the yearly savings from raising the deductible by 2.5 and the comparing that number to the difference in deductible amount (ie, the “extra” out of pocket you’d have to pay in event of a loss/claim). What is the 2.5 factor based on??

            You stated that the average HO makes a claim approx every 10 years. That would reasonably be expected to be even less often for those with newer homes, who are diligent about maintenance, and who live in geographic areas unlikely to be affected by major weather events.

            So why shouldn’t the multiple be 10? Or even greater in certain “lower risk” situations?

  2. I was pretty much convinced that you were Michael P who works as a rep for a large Mutual insurance company.

    But . . . you must not be.

    Anyone working for an insurance company would know that the factors you’re suggesting are already figured into the homeowner’s policy’s rate. That base rate is multiplied times a factor for the discount given for a larger deductible.

    You seemed to be hung up on what constitutes a “rule of thumb”. I have no idea where the 2.5 factor came from. It was taught to me and seemed quite useful over the last four decades, which is why I stated it here.

    I’ve sold many, many millions in insurance premiums over the years. As you can find out readily on line, I’m a top producer for many of the major insurance companies.

    If you are the Michale P I think you are, we place a huge amount of business through your company . . . using many “rules of thumb”.

    I’m confident that most large deductibles appeal more to the ego of those able to afford them than they do to the economic sense of the transaction.

    Jim

  3. I don’t have anything against raising the deductible on home owners insurance. If it saves some money on your premiums it can be worth it. However, I don’t think you should ever raise it above what you are willing to pay out of pocket.

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