A strategy for evaluating insurance deductibles.
OK, today let me drop a little insurance strategy on you to help you “evaluate your insurance premium savings quantitatively by increasing your risk retention”.
Got that? That’s a real “fancy-pants” way of saying, “save money by increasing your deductible”, but now you can sound important-like and impress your insurance-geek friends. Just one word of caution: don’t try that one at a party unless you’d rather be alone.
OK, bad insurance humor aside, it’s commonly known that by increasing your deductibles will generally lower your cost of insurance. But today, I’ll give you a strategy to analyze the premium savings to see if it makes sense to take on more risk.
It’s important to understand that insurance is provided by an insurance company on a “cost plus basis“. What that means is that very smart mathematics types (known as “actuaries”) figure out the dollar amount of the frequency and severity of losses that the insurer is likely to have to pay for the risks they assume. Think of this number as just the “pure” loss amounts, without any expenses associated with them. Let’s call that number “X”.
Once that’s done, the financial bean-counter guys and gals get together and add in the costs the company must bear to administer their customers’ losses, such as employing people and costs of adjusting and paying for the losses. Let’s call that number “Y”.
Then finally, once that’s done, the management types (you know, the one’s dressed in suits) add a cost which represents the percentage of profit they want to make. Let’s call it 10%. So the cost of insurance is figured like so: (X + Y) * 1.10.
Sounds too simplistic? It’s closer to reality than you think.
OK, so let’s go back to our generally misunderstood actuary friends (they need love, too). They know that if you take a $100 deductible instead of a $1000 deductible, their frequency of loss will increase, because you’ll be tempted to put in that $250 loss claim now. If you had chosen a $1000 deductible, they’d never see the claim. So, what do we learn from this?
By choosing low deductibles, you are trading today’s insurance premium dollars for future potential claim dollars.
The reason and logic should be clear from the example above: the company has to charge more to pay for its increased likelihood of loss, which also includes the very real and expensive loss adjustment expenses. And because you are paying premiums on a “cost-plus” basis, this is generally speaking a bad deal for the consumer because you are not only “prepaying” your small claim but you’re also paying for the insurance company’s costs and profit-margin targets.
If I haven’t lost you yet, here’s a very simple method of evaluating whether or not increasing your deductibles is a good “buy” for you. It assumes that you have the financial capacity to pay that deductible if/when the loss occurs- Remember: the fundamental rules of personal risk management dictate that we do not take on more risk than we can handle and we never risk a lot for a little.
So with those caveats aside, here it is: If today’s premium savings can “pay for” the difference in deductibles within 3 years, it’s probably a good idea to increase the deductible (assume more risk) and take the premium savings.
Say you have a policy with a $250 deductible that costs you $1000 per year. Your agent advises that the premium would decrease to $750 if you chose a $1000 deductible. So your out of pocket premium savings is $250/year (nice!), but your out of pocket risk has increased $750 (not so nice). Since the annual premium savings of $250 * 3 = the difference in our deductible ($750), it’s generally a good strategy to increase the deductible.
Of course, if you do have suffer a loss within 3 years, you’ve “lost the bet” so to speak, but it’s sting is tempered by your retaining the first year’s premium savings. On the other hand, any loss 3 or more years in the future has paid for itself. Actually, and then some, since premiums tend to rise more or less, every year. The percentage rate increase will be less with a $1000 deductible for example, than a $250 deductible, in keeping with our example.
Now that you got this down, call your agent, save some money (if appropriate) and then go treat yourself to something nice (some chocolate, an ice cream, maybe a new car…) because you’re now a much more savvier purchaser of insurance than you were mere moments ago.
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