Insurance for Real Estate Owners: How Much Of A Property Deductible Should You Carry?Real Estate Coaching Financial Planning
By stephen j. meyer
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What you'll get from this article:
🏠 insurance terms every property owner needs to know
🏠 what is a coinsurance penalty?
🏠 THE INSURANCE COMPANY'S VIEW OF THE DEDUCTIBLE
🏠 when to increase or decrease a deductible
🏠 Treating a moderate deductible like a high deductible
You are shopping for a landlord policy and you must decide on the terms. A lower deductible means higher premiums. How do you decide how much of a property deductible to carry?
How Insurance Works
At its heart, insurance is a financial mechanism to transfer a financial risk. I admit that is worded a little strangely, but that distinguishes it from other risk transfer mechanisms. Insurance does not make risk go away; it just moves the financial part of the risk to someone else in return for a premium payment.
The purpose of insurance is to transfer a financial risk that is so large that our lives would be overly affected if we had to bear it ourselves.
There are non-insurance ways to transfer risk. For example, one of the most basic risks we face as property owners is one of our properties burning to the ground. We could transfer this risk by simply selling the property, but then we would lose the benefits that come from property ownership. Insurance offers a financial mechanism in which we pay a premium so the insurance company takes on that risk (along with other risks we will discuss in other posts.) As with life insurance, property insurance won’t change the odds of the property burning (and, if it is your home, it won’t replace the mementos that do not have any cash value but are still precious to you), but it will pay to rebuild the property.
Insurance terms every property owner needs to know
To answer this question about how much of a deductible to carry, there are other basic terms you need to know:
Replacement Cost: This is how much it would cost to rebuild the insured property. Insurance companies typically require you to buy coverage to replacement cost. They do this because their ratemaking formulae -- how they determine what to charge -- assume that you buy full replacement cost coverage.
Since most property losses are for significantly less than the full replacement cost, a risk-taking buyer would get an “actuarial bargain” if they were allowed to purchase coverage for less than replacement cost.
Coinsurance Provision: This requires that the insured purchases a policy which covers the replacement cost of a property to a specified percentage of its full value.
Coinsurance Penalty is the amount the insured pays for a loss the insurance will not cover. Although you might somehow manage to purchase coverage for less than full replacement value, when the insurer’s adjuster figures that out when you have a claim, you will be assessed a coinsurance penalty.
With a coinsurance provision, whatever percentage of replacement value you purchased is the percent of any claim you will recover. For example, if you bought $75,000 of coverage on a $100,000 property, the coinsurance penalty would be 25% (1 - $75,000/$100,000). That means if you had a claim where they would normally pay $20,000, then they will only pay $15,000 due to the 25% coinsurance penalty.
Deductible: This is the amount that you pay on each claim. For example, if you have a $5000 deductible and a $20,000 claim and have purchased insurance for full replacement cost, the insurance company would pay $15,000.
Although nobody likes paying cash out of pocket, deductibles can be our friends because they lower the premiums for our insurance policies.
How insurance companies view deductibles
From the insurance company’s point of view, insurers save the deductible cost, of course, but perhaps even more important than that is their savings in administrative costs. Experience has shown that, if there are no deductibles, then policyholders will make claims for even the most trivial of losses, like a broken window. While replacing the window does not cost that much, the insurer would have to hire many more adjusters to handle all those additional claims.
Here is a graph that will help to explain the insurer’s point of view on deductibles:
This graph answers the question “If a property loss occurs, what are the odds that it will be a particular size?” It shows that the vast majority of the property losses are relatively small, like broken windows, burglaries, and the like. There are “medium size” losses, like water damage or partial roof collapse, but the odds of larger and larger losses get smaller and smaller until you get out to close to 100%. The reason the line pops up at the end is that the house can burn to the ground, and even if it is not completely burned down, after certain point it is cheaper to just raze what is left and build over.
This graph explains why you can save money through a deductible, but the amount of money saved shrinks as the deductible gets bigger; most claims will be less than one percent of the property’s value, so the insurers cut out a lot of claims with even a small deductible. Once you get out to five or ten percent of the property’s value, though, you are not cutting out many additional claims, so you will probably find the reduction in policy cost is disappointingly small.
What is the ideal size of a deductible?
There is no “one size fits all” for deductibles since the size of an expense a property owner (rental or personal) can absorb without changing lifestyle varies; the loss that’s easily absorbed by an owner with low leverage may be a significant cash crunch for a highly leveraged owner. Here are some other considerations:
When to consider increasing a deductible
While you won’t save much money if you increase your deductible in the flatter part of the curve, you can save a lot within the steep part of the curve; if your deductible is much less than 1% of the property replacement cost, then you can undoubtedly save good money by increasing it.
When to consider lowering a deductible
On the other hand, if your deductible is above 5%, then you probably are not saving very much compared to the additional risk you are taking on, so you might find that a lower deductible doesn’t cost much more.
Finding the sweet spot
The above points imply that there is a “sweet spot”, where the savings change from “Wow – that’s good money saved” to “Meh; that don’t save me much.” Ask your insurer or agent to quote a few different deductibles so you can see how much you save for taking on additional exposure. They may not be thrilled to have to work of several different quotes, but they will be happy with a satisfied customer.
Tax treatment can influence deductible size
The deductible on your rental property insurance can generally be higher than on your homeowner’s policy. That is because a deductible on a landlord policy that is paid for a covered loss can be treated as a business expense. This is different from homeowner’s insurance, where your personal property insurance deductible for a covered loss is paid with after-tax money.
Treating a moderate deductible like it is a higher deductible
In our own rental property business, we have a deductible that is in the sweet spot, but we actually act like we have a higher deductible.
We can easily finance a $10,000 claim on one of our single family properties with cash reserves, but we have found that we don’t save much in premiums by buying a $10,000 deductible verses a $5,000 deductible. That is why we have a $5,000 deductible that we treat like it is $10,000 -- meaning that we won’t make a claim for a $7,500 loss.
I will discuss the reasons for this treatment in future blog posts, so stay tuned!
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