Your home may be one of your largest assets. You protect that asset with an insurance policy. Like most insurance policies there is a deductible, the amount of money a claim must pass before the insurance company will start to reimburse you for expenses associated with the claim. Some policies have a single deductible for all types of claims covered on the policy. Some policies have “special” deductibles for specific claims (wind, hurricane, tornado, earthquake). All policies have exclusions for what they will not cover. Earthquake and Flood are two of the major natural disasters that are excluded from most policies. We will talk about coverage for these risks in future articles.
Types of deductibles
There are two types of deductibles. The most common is a Dollar Amount Deductible. With this type of deductible, you choose a dollar amount ($250, $500, $1,000, $2,500, etc.) that you are responsible for in the event of a claim. After that the insurance company will reimburse you for covered expenses associated with the claim. For example, a tree falls on your home and causes $4,000 in damage including the cost to remove the tree and repair the home. If you have a $1,000 deductible, the insurance company will reimburse you for the additional $3,000.
The second type of deductible is a Percentage Deductible. With this type of deductible, your deductible is equal to a percentage (1%, 2%, 5%) of the insured value of the home. If you home was insured for $400,000 and you had a 1% deductible you would have a $4,000 deductible. If we used the above example with $4,000 in damage, your policy would not provide any coverage as it did not exceed your deductible. With this type of deductible, as your home increases in insured value your deductible increases.
How to choose a deductible
As you can see from above, your deductible will determine when you can put a claim in for payment. Your choice of deductibles affects the cost of your policy. The higher the deductible the lower the cost of your insurance. On the flip side, the higher your deductible the more you must pay out of pocket in the event of a claim. How do you balance saving money and being stuck with a claim you cannot afford?
There are several theories of how to choose the correct deductible. You need to keep in mind 4 things
- How much premium will I save if I increase my deductible?
- How many years will it take me to save the increase in my deductible?
- Can I afford to pay that deductible out of pocket at some unknown claim time?
- At what dollar amount would I want/need to be reimbursed for a claim?
My theory is if you can save the increase in your deductible in three years or less, you should increase your deductible. If it takes between three and five years to save the increase in your deductible you should think about it. If it takes over five years to save the increase in your deductible it may not be worth it. All of these are also based on what you can financially afford to pay as a deductible at claim time. Keep in mind, on average there is a home claim every seven years. If you put in several claims over a short period of time the insurance company is likely to cancel your policy or increase your rates. Proper deductibles are an important part of risk management.
In this example we will use a home insurance premium of $2,000 and your current deductible is $500. You have a choice of going to a $1,000 deductible, $2,500 deductible, or a $5,000 deductible. If you increase your deductible to $1,000 (a $500 increase in your exposure) you save $250. If you go to a $2,500 deductible (a $2,000 increase in your exposure) you save $450. If you go to a $5,000 deductible (a $4,500 increase in your exposure) you save $700. Saving $700 sounds like a good option as you are saving 35% of the premium but let us do the math.
- $1,000 deductible: You increase your deductible (exposure) by $500. You save $250 per year. It would take you 2 years to save the increase in your deductible in premium dollars spent. This would be a very good option. In four years, you have saved your entire new deductible.
- $2,500 deductible: You increase your deductible (exposure) by $2,000. You save $450 per year. It would take you 4.4 years to save the increase in your deductible in premium dollars spent. This would be something to think about, depending on your finances. If you have a $2,500 deductible, when do you put a claim in? You would not put a $2,600 claim in to get $100 back and have a claim on your record. Would you put a claim in at $3,000 maybe $3,500? That is what you need to think about. Do you have that cash set aside for a claim at an unknown date?
- $5,000 deductible: You increase your deductible (exposure) by $4,500. You save $700 per year. It would take you 6.4 years to save the increase in your deductible in premium dollars spent. This may not be in your best interest. If you have a $5,000 deductible, when do you put a claim in? You would not put a $5,100 claim in to get $100 back and have a claim on your record. Would you put a claim in at $6,000 maybe $6,500?
You need to have the cash at an unexpected claim time to be able to “afford” the higher deductible. When choosing an insurance policy, you do not want to focus just on the annual premium. You need to pay attention to how you are being covered. Two policies that are insuring the home for the same value may have completely different policy wording allowing one policy to provide much better coverage. Internal policy wording impacts if and how much you will be paid at claim time. We will discuss that in future articles.
Brian P Boak, AEP, CPRIA, CLU, LUTCF
Private Client Risk Advisor, P&C
BOAKS Advisors 973-570-6381 www.BOAKS.com