Volume I: Your Deductible Is Too Low
Editor’s Note: This is going to be a record setting week…for the first time, there will be not one, not two, but three posts in a week! There will be a follow up to this tomorrow and then my Super Bowl predictions are due on Friday.
I’m going to try something new today. Instead of pointing out mistakes insurance companies make, I’m going to point out mistakes insurance buyers make. If people like it, I’ll make it a recurring feature.
Note, buyers make these mistakes because insurance companies encourage them to do so. Whether it be to close a sale faster or improve margins or just because it’s easier, insurance is largely sold on a buyer beware basis.
At the end of the day, people act in their best interest and the majority of agents/brokers – like nearly all professions – are short-sighted and act in their near-term interest, even if it increases churn in the long term or results in lower customer satisfaction.
Because insurance is complex, agents understand the average customer isn’t going to figure out if they didn’t get the best advice. The temptation to do what is expedient is great. Only the truly superior agents resist the call and accept lower margins to focus on what the customer expects.
Yes, all this is a little bit self serving which I’ll tell you more about tomorrow. Hopefully, you’ll understand the synergy then.
With that setup, what is this all about? The goal of this proposed series is to help insurance buyers, especially retail ones, make better decisions.
Now, I know, many of you reading are insurance professionals and think you couldn’t possibly need any help. I can assure you, I have had many a conversation over the last year and change with people just like you who make the same common mistakes as the average Joe and Joanna.
The Most Common Mistake
Today’s topic will be an easier one. They will get more complex over time, but let’s start with the most common mistake I see insureds make – picking too low a deductible.
Quick conclusions upfront:
– Low deductibles are one of the worst risk-rewards in your policy
– Agents should explain why they are a bad deal, but rarely do
– Insurers should encourage higher deductibles but worry about the expense ratio impact
It’s really quite amazing. Every insurance commercial is about saving money, saving money, saving money.
And yet, the easiest and smartest way to save money is so obvious and hardly anyone does it. Self funding your deductible is one of the best decisions you can make. Low deductibles are incredibly overpriced (as I will show later).
Most of the things insurers do to save people money are acting against the customer’s interest (giving up coverage and taking more risk, all of which the buyer is largely unaware). Yet, they don’t suggest raising your deductible to save, even though this truly is in your best interest.
We all know why this is. Consumers might object to a higher deductible because they know that’s a risk and they may be uncomfortable with it. On the other hand, the risk they don’t know they’ve taken to save money brings no objections.
It’s all smoke and mirrors though. Are you as an agent there to close the easiest sale or do what’s best for the customer?
Before we do some math, let me put this in a way that is probably more intuitive to many here. When you buy a reinsurance tower, you can either take a low deductible and participate up the side or, for a similar price, take a higher deductible and buy full coverage above the deductible.
What’s happening with retail insurance (personal lines + small commercial) is customers are taking the low retention without realizing they are participating up the side.
They didn’t outsmart the insurer and find a better deal. They took extra risk unknowingly. If they had a better understanding of what they bought, there is a good chance they would choose the higher retention with full coverage.
Running the Numbers
So let’s look at the numbers to better understand why. I’ll focus on homeowners for now. Average frequency is about 6%, so, simplistically you expect a claim every 16-17 years (though that’s not the exact right way to look at which I’ll discuss tomorrow).
Insurers price for a claim about once every ten years (of course, this differs by insurer, but this is consistent with rate filings I’ve looked at). If you’re the insurer, this isn’t unreasonable.
After all, if you collect $10 vs. an expected loss of $6, you have a 60 loss ratio. Seems about right! If you buy a low deductible, the insurer needs to make money at it.
So what’s my issue? Your insurance agent is supposed to be looking out for your best interest, not the insurance company’s.
In other words, they should be helping you buy coverages that are most attractively priced for you and avoid those that are poor risk-reward.
Now, not everyone can afford the higher retention, but, if you can, it is clearly in your interest to do so rather than let the insurance company earn a margin on you.
When you shop a policy, one of the first questions you should be asked is, “what is the highest deductible you can afford?”. How many agents ask this?
If your agent tells you to stick with a $500 or $1000 deductible, that is like someone at the casino telling you, “play the slots, not craps. You’ll lose more, but it’s easier”.
Where Insurers Get It Wrong
Frankly, insurers themselves should realize it is in their best interest to explain this to the customer. If you want to convince the customer that home insurance is not a maintenance policy, the best way is to steer them towards higher deductibles.
Let’s be honest, the main reason people don’t like the insurance company is because of a bad claims experience. If your customers raised their deductible from $500 or $1000 to $5,000 or $10,000, you eliminate a lot of small claims and a lot of disputes and your adjusters would probably get better at larger claims because it’s where they would spend all their time.
But alas, this would shrink the top line in the short term and that might impact the expense ratio. Let’s examine how an insurance executive would look at the issue:
Assume a 92 CR (65 LR, 27 ER) target. Raising the deductible from $1000 to $5000 could easily lower premium 20%.
Thus, a policy with $1500 of premium should generate $120 of underwriting income. But if the premium drops to $1200, even though my loss $ drop, my expense $ stay the same (other than a drop in commission) and my underwriting income drops by more than half!
| $1000 deductible | $5000 deductible | |
| Premium | $1500 | $1200 |
| Loss @65% | $975 | $780 |
| Expenses | $405 | $370 |
| U/W Income | $120 | $50 |
In other words, on a marginal basis, much of the profit in the policy comes from the low deductible!
While this may be true on a day one basis, there is no reason the expense load couldn’t be adjusted over time (remember, we’re having fewer small claims now) and get things back to where they were.
However, how many execs want to deal with explaining the adjustment period? Too few, which is why the insurers keep their mouths shut and hope their agents do the same.
But then there are nuisances like me who like to point these things out so we can have a more efficient market. Sorry!
So What’s the Right Deductible?
If you’re saying to yourself, this all sounds interesting and I probably do have too low a deductible, but how do I know what the right deductible is for me? Don’t worry, I’ve got you covered.
Stay tuned for tomorrow’s post where I’ll show you more of the math behind deductibles and an easy rule to judge when they’re in your favor.