Why Deductibles Make Sense

It’s natural to not like to have to pay money when one’s vehicle becomes damaged from an accident or other insurable event. We often have the attitude that auto insurance is supposed to compensate us for such things and when it fails to do so completely, we feel less served by it.

Deductibles are set up to have us bear the first portion of the cost of an insurable claim, where we pay the first $100 or $250 or $500 or whatever our deductible portion of the claim may be. Different coverages are treated separately, with collision and comprehensive for instance offering separate amounts that may be selected.

Why Deductibles Make SenseIf the amount of the claim does not exceed the deductible amount, nothing is payable. Deductibles get their name by having the amount deducted from the amount of the claim or potential claim with the amount remaining consisting of the payment that the insurer’s portion of the claim.

This is perceived as a lesser form of coverage and some may think that they are even underinsured with deductibles in effect. Insurance companies never used to offer auto insurance without deductibles until fairly recently, as they recognized that there is a real market for this and especially when competitors offered them.

In a free market, if there is enough demand for something and it is practical for a company to offer it, it will be offered, and this is exactly what has happened with lower deductible and no deductible policies. Whether or not lowering or eliminating deductibles makes sense is another matter though.

If doing so did not involve any additional cost, then it would be smart to seek to reduce deductibles whenever possible, but this extra insurance does cost money and in fact costs significantly more than you can expect to get back.

This is not to say that it never makes sense to reduce one’s portion of a claim or get rid of it altogether, but we at least need to be thinking about these things in an informed way to be in a position to be able to decide this properly.

We Need to Realize What Insurance Really Should Be Doing

While many people think of insurance as simply a means to compensate us for certain losses, this actually isn’t thinking about insurance the proper way. Sure, it does pay for insured events instead of our having to pay for it, but this does not necessarily mean that it is always desirable for insurance to cover something rather than our covering it.

Ideally, we would never need to purchase insurance, as insurance always ends up being in itself a bad bet. This does not mean that it does not have its place, and it certainly does in many cases, but in some cases it does not.

Whenever we purchase coverage, we may expect, on a balance of probabilities, to pay a lot more than we may expect to get back. This is not unlike playing the lottery, where you know that this will cost you several times any expected wins, but at least with lotteries we get entertainment value out of it, the excitement of having a chance to win a lot of money even though the odds of that are very long.

With auto insurance, we may not mind paying quite a bit more for a coverage than we can expect to get back in claims, if losing the value of the vehicle may represent a major financial hardship upon us. An example would be having to make payments on a car for several years after its value becomes lost, which may leave us unable to afford to buy another one.

When it comes to deciding whether or not we should insure something, we need to always ask ourselves what the ramifications of the contemplated loss would be, the loss that we are considering insuring against.

It is never a pleasant thing to lose the value of anything or have it diminished for that matter, but if we’re able to handle it ourselves, then it really doesn’t make sense to pay extra to insure it.

Insurance Needs to Have Enough Value for Us

An insurance decision is never about not coming out ahead overall, it is about deciding between being subject to a loss if an event happens or an even bigger one that is spread over time to make it more affordable. If we really are concerned about losses, we need to consider that the money we spend on the insurance is money we would have been able to keep for ourselves otherwise.

This is similar in some ways to buying something on credit and pay for it over time, where this will cost us a fair bit more depending on the interest rate we pay, but if we need it now this can be well worth it.

We might even decide that we just want it now and the extra money we spend on interest is worth it, meaning that the extra satisfaction or utility that we get from having it now is worth the bigger price.

Many people buy things on credit without thinking very much about this, to their financial detriment, and may even end up spending more than they can repay, which happens all the time.

We don’t want to be doing that with insurance either, and the number of people who purchase extended warranties to protect themselves against losing items of fairly nominal value are great, even to the extent that those who offer these warranties can inflate the price a lot higher than would even be reasonable and still have many paying it.

We would have to be in pretty dire straits to need to worry about taking on the risk of bearing a loss of just a few hundred dollars, and even though there are some who are in this situation, most people aren’t, and can at least borrow this much money if needed.

The value of insurance to us is knowing that if an event happens, we will be able to bear the financial costs of it. There are some things that we can bear and some we cannot, and we need to start by knowing the difference, which can only happen when we actually think about these things.

If we can bear it and we are still insuring against it, we are really just throwing away our money. All insurance is on balance a bad deal but it can and often does prevent an even worse deal, an intolerable one even. If what we’re looking to protect against isn’t bad enough, whereby it is not worth it to spend extra money on it, then this is essentially the same thing as buying something on credit and paying extra in interest without a good reason, frivolously in other words.

Deductibles Are by Nature Smaller Amounts

The risk with deductibles is defined by their amounts, where a $250 deductible risks us spending that much, a $500 deductible carries the risk of spending $500, and so on.

Unless we are in a situation where we simply cannot access this much money, or perhaps only with a payday loan with their extremely high rates, it simply does not make sense to ever purchase this extra coverage.

If we can manage quite comfortably without insurance with a given risk, then not purchasing it is always the best option, because insurance really only makes sense when we use to manage unmanageable situations.

The amount of money lost due to a deductible simply is not even close to that category for the great majority of people who buy down these deductibles.

There is another reason and a significant one why this is not a good idea. Whenever we make a claim with an insurance company, this will affect our risk profile overall, and generally have us pay considerably more for comparable insurance after the claim is made.

Let’s say that we purchase full coverage on our vehicle and we have an accident which costs $1000 to fix. We may pat ourselves on the back for not bearing this deductible and paying for the repairs ourselves, but in addition to the money that it had cost us over time to buy this, our making another claim will generally have our premiums increased.

Even in cases where a company may tell you that it will forgive the first claim, do you really want to use it on something like this? Insurance companies do not give away such things for nothing and this will mean that it is priced in to the policy, but if you are paying for this, you don’t really want to waste it on such a minor claim.

More likely, in addition to the added premium cost of the deductible waiver which everyone pays, your rates will probably go up and this whole situation could end up costing you much more than the added premium costs when you first purchased it, and cost you a lot more for a quite a while in fact.

The fact that you can just pay for this yourself is actually a pretty big benefit, and there is actually a threshold where it makes sense to not submit a claim due to concerns about how it may affect future premiums, and deductibles are always within this threshold.

It may be actually preferable to not submit these smaller claims even if the insurance company would pay for the damage for you.

If the incident exceeds the deductible amount, you will collect the excess portion in both cases, with or without the waiver, but insurance companies hate paying out money and will account for these amounts in future pricing. At the very least, you may be risking paying more for your insurance if the amount of the claim is higher due to the deductible portion being covered.

Waiving any deductible amount should be limited to those who simply cannot bear the loss of this small amount of money, and while they may wish to purchase it for now, their goal should be to improve their financial situation as soon as possible and then change their coverage to bear the deductible portion once they are better situated.

Needless to say, this is not how most people or hardly anyone sees deductibles, but they are nonetheless almost always a waste of money and a bad idea.

John Miller

Editor, MarketReview.com

John’s sensible advice on all matters related to personal finance will have you examining your own life and tweaking it to achieve your financial goals better.

Contact John: [email protected]

Topics of interest: News & updates from the Securities and Exchange Commission, Stock Markets, Bonds, Loans & more.