Why We Treat Our $5k Deductible Like It’s $10k
Financial PlanningThoughts on How Much of a Property Deductible You Should Carry – Episode 2
What you will learn from this article:
In my first post, I gave some thoughts on selecting the size of the deductible for the insurance policy on your home or investment property. The thoughts applied to the deductible on both personal and investment properties. In this episode, I’ll discuss why we treat our $5,000 deductible as if it were a $10,000 deductible.
An insurance company’s underwriting process
There are a number of elements that determine the premium your insurer will charge for property insurance, including:
- Location
- Replacement cost
- Material it’s constructed out of
- Distance from an earthquake fault
- Distance from the nearest fire station
as well as other factors.
Most of these elements will be reflected in surcharges or discounts to the general rate (for example, a wood house would pay more for the “fire” part of coverage than the house next door that’s made of brick.) Others, though, may be reflected in the underwriting program where the insurer places the property. A house that’s out “in the middle of nowhere,” for example, might not be eligible for an insurer’s lowest-rated program because it will take longer for police and fire professionals to get to it, and if repairs are needed, the contractors may well charge more to reflect their additional travel time.
"Zero claims" status impacts your property insurance premium less than you think
One item that isn’t directly considered (but which many people believe is considered) is how much money your insurer has made from insuring your property over the years. You may think that the insurer should decrease your premium (or at least not increase it) if you’ve never made a claim since they’ve made money on you.
While this thinking is understandable (and it is true that some insurers give “no claims discounts”), insurers really don’t think about your policy in that way. To see why, consider what would happen if your property is struck by lightning and burns to the ground, but the person in the identical house next door suffered no damage; should your premium go up while your neighbors’ goes down even though it was pure luck that the lightning struck you rather than them?
The answer (based on the information provided here) is no; the premiums charged to both of you should reflect the fact that your houses may be struck by lightning, not the pure chance that one house was hit rather than the other.
What about “no claims” discounts?
In terms of insurance company thinking, the “no claims discount” is a marketing tool to A) prevent you from feeling like they don’t appreciate you and B) make you want to renew with them so you don’t lose your discount.
The way insurers set rates is to make sure they charge enough to each house they insure in your area so they can pay for the unlucky house that gets struck by lightning (along with all of the other perils your home faces.) For this reason, the rates property owners pay in one area tend to all move up or down together rather than individually to reflect each home’s claims.
How the number of claims you make impacts your premiums
There is, however, one way in which your own losses can affect your insurance rates, and that is the number of claims you make. The reason for this is that it may well determine which underwriting program you qualify for. We found this out ourselves when we were starting out as rental property owners.
Here’s the background:
When we bought our first rentals, our plan was to move the properties into our LLC when it was ready. However, before we were ready to do that, we had a pipe burst in one of the properties. That property had insurance, of course, and we made a claim under that policy. The next year we had a pipe burst in our own house, so we made a claim on our homeowner’s policy.
A few years later, Hurricane Sandy blew through our area, and we lost some trees on our property. Since there is coverage for debris removal on homeowner’s policies, I notified our insurer that we might have a claim but told them I wasn’t sure if there would be enough damage to make a claim. As it turned out, the cost of debris removal was less than our deductible, so we didn’t make a claim.
Insurance claim history is tracked like your credit
Everything copacetic, right? Well, I got a surprise the next time I went to get some quotes on the policy for our home. (Remember, as I said in my first blog post, this is something you should do from time to time because you might find a better deal.) The agent said, “Well, I see you’ve had three claims in the last 4 years, so you aren’t eligible for our preferred rates!”
I was only slightly surprised that the insurer could see we had three claims, even though one was for a different insurer and in another state. It might seem invasive that databases exist that allow insurers to see how many losses we’ve had on all of our properties, but those databases do exist. If you want to feel better about them, you can consider that they allow for greater competition since a new insurer will be able to get information that would otherwise only be available to an insurer with a dominant market share.
I tried to explain that the one claim was on a rental property, not our house, and that we didn’t even make a claim for Hurricane Sandy, but to no avail; our first claim was under our name, and our insurer had recorded Sandy as a claim so we had 3 claims and were not eligible for the insurer’s preferred program.
What we learned from our call to our insurer after Hurricane Sandy
Knowing insurance companies as I do, I estimated our chances of successfully convincing our insurer to delete our “Sandy” claim to be roughly the same as our odds of winning Powerball (but less fun), so the only thing left for us was to learn from the experience. What we learned was:
- In addition to liability protection, having an LLC would have meant that the first claim would have been recorded against the LLC instead of us.
- In the future, we’re going to be sure that we have a substantial claim before we report an event. By “substantial”, I mean that we are going to get a significant amount paid on our claim. We’re not going to report a claim that might be a little more than our deductible.
For example, if we have a $5,000 deductible, we’re not going to report a claim that will be in the $4,000 to $6,000 range.
This is why I said in the headline that we would treat a $5,000 deductible like it is a $10,000. Even though all of our investment properties are in LLCs so the chances that we will have three claims in four years again are very small, the amount of money saved by being eligible for insurers' “preferred” programs can be considerable.
Parameter risk
In insurance terms, the insurer is concerned about what is known as “parameter risk”; insurers have data to estimate how much an average policy for your type of property will pay out each year, but there will be people who are better or worse than average.
The insurer doesn’t know if you smoke in bed, store flammables near the furnace, etc. (which would tend to increase losses), or if you are meticulous about caring for your property (which would tend to lower your losses), but it sure would like to know. An obvious indicator of where you lie on that spectrum is how many claims you’ve made.
As an aside, parameter risk is also an issue auto insurers face; although they can estimate how often you should have an accident on average based on stuff like your age, sex, where you live, and how far you drive to work, those things don’t tell them how you drive; do you mainly drive cautiously on empty roads, or do you weave in and out of traffic on a busy interstate. Some insurers now offer apps which, among other things, monitor how you drive. This gives the insurers very good information on where you are on the driving “spectrum.” If you do, indeed, drive slowly on empty roads, then these apps will undoubtedly save you money, but if you do weave…well, if you want to buy a policy from such an insurer then you might want to turn your phone off while you’re in the car.
Reporting a claim close to the deductible is a judgment call
We understand why an insurer would have looked at our 3 claims in 4 years and decided that we were on the “worser” end of the risk spectrum, and we want to make sure that, in the future, our claims truly do reflect where we are in the risk spectrum. For this reason, we won’t make a claim that is only “a little” over our deductible.
Although I have said we treat our deductible as if it is $10,000, the truth is that if we had a $9,000 claim then we would probably make it. This is why I put “a little” in quotes – I can’t define how much more than $5,000 the claim would have to be, but I feel confident that, if the time comes that we have a “medium sized event”, we will know whether we want to make a claim.
It could reasonably be asked why we wouldn’t just increase the $5,000 deductible to $10,000. The reason for this is, as I discussed in my first blog post on insurance, we settled on a $5,000 deductible by pricing different deductibles and finding the money saved by going to a $10,000 deductible was fairly small. It is worth it to us to pay a relatively small additional amount of premium up front and know that, although we might have to pay more than $5,000 on a “medium - sized” event that isn’t worth making a claim on, we’ll be limited to $5,000 in the event of a larger claim.
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