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Deductibles

Deductibles are amounts which are subtracted from claims made by policyholders and for which insurance companies are not liable. A deductible is therefore a cost which is borne by a policyholder in a claim, and to that extent it amounts to a sharing of the claim liability with the insurance company. For example, if your auto insurance policy has a deductible of $500 and you have an accident causing $800 in damage to your car, the insurance company would only pay $300. You would have to cover the first $500 in damage yourself.

In general, deductibles only apply to the comprehensive and collision portion of your coverage. If you have comprehensive or collision coverage under your policy, a deductible is standard.

The policyholder chooses the amount of the deductible, subject to meeting the minimum amount specified by the insurance company. In practical terms, the deductible is usually selected from a limited range offered by the insurer. For auto insurance, the most common amounts available are $250, $500, $1,000 and $1,500.

Why do deductibles exist?

Deductibles are included in insurance policies for two main reasons, both of which help keep premiums more affordable:

Deductibles
Key Points:

  • Applies to collision and comprehensive only.
  • A higher deductible will lower your premiums.
  • Calculate the break-even period for each deductible available.
  • Estimate your expected accident frequency.
  • Compare both, then choose your deductible.
  1. Having a deductible eliminates relatively small claims, which incur a disproportionately high level of processing costs. Processing a claim requires a certain minimum time and effort which is largely independent of the amount of the claim. The administration costs of a small claim would constitute a large percentage of the claim itself.

  2. More importantly, a deductible gives the consumer some ‘skin in the game.’ Without a deductible, the average consumer would be unlikely to exercise as much care or caution to avoid a loss if they knew that the total amount of any loss would be fully covered. This would expose the insurance company to even greater risk.

What impact does the deductible have on my premium?

A lower deductible generally correlates with a higher premium, and vice versa. This is because a lower deductible is likely to result in more claims and therefore greater cost to the insurance company.

What deductible should I choose?

When purchasing any insurance policy, it is important that you keep in mind the primary reason for obtaining coverage. For the vast majority of people, the primary purpose of insurance is to cover large, catastrophic losses, not to reimburse you for every minor loss you incur. With that in mind, you should generally choose the highest deductible you can afford to pay in the event of a claim in order to minimize your premium. This, however, is only a starting point for selecting a deductible. You also want to maximize your value for money, and sometimes the best value policy may have a deductible that is much lower than the maximum you could afford.

The reason for this is that the relationship between deductibles and premiums is not linear. Initially, each increase in a deductible will result in a large reduction in premium. But as you increase the deductible even further, the savings in premium get less and less. For example, assume you choose a deductible of $250 and your premium is $1,000. If you increase your deductible to $500, your premium might drop to $800. If you double your deductible to $1,000 and your premium might only drop to $700. Increase your deductible to $1,500 and you might only save another $25, paying $675 for coverage.

In the situation above, even if you could afford to cover a deductible of $2,000, choosing this level of deductible is not the most optimal option. Look at it this way:

  • Premium of $675 – Buys coverage with a $1,500 deductible.

  • Premium of $700 – By paying an additional $25, you lower your deductible to $1,000. You would only need to make one claim in 20 years to recover the additional premium ($500 extra coverage divided by $25 extra premium per year = 20 years).

  • Premium of $800 – By paying a further $100, you lower your deductible to $500. At this premium level, you would need to make one claim every 5 years to recoup your additional premium ($500 extra coverage divided by $100 extra premium per year = 5 years).

  • Premium of $1,000 – By paying a further $200, you would lower your deductible to $250. At this premium level, you would need to make one claim every 1.25 years to recoup your additional premium ($250 extra coverage divided by $200 extra premium per year = 1.25 years).

The optimal policy is likely to be either the one with a premium of $700 and a deductible of $1,000 or the one with a premium of $800 and a deductible of $500, depending on what you could afford to pay in the event of an accident, and your expected rate of accidents.

Break Even Period

A useful way to choose a deductible is to calculate a break even period, and then compare that with an approximate frequency of making claims under your policy. The break even period is the period in which the accumulated premium savings you make from choosing a higher deductible are equal to the increase in the deductible itself. For example, if you pay $100 per annum less in premiums in exchange for an increase in your deductible of $500, then your break even period is five years ($500/$100). That is:

Break Even Period = Difference in Deductibles ÷ Difference in Annual Premiums

But how often can you be expected to make a claim under your policy? That depends on a range of factors, including the following:

  • Your experience as a driver;
  • Your driving habits and skills;
  • How far you drive each year;
  • The state and area in which you live;
  • The usual times of day you drive; and
  • The safety features of your car.

Each year, based on actual claims statistics, Allstate releases a report which ranks the 200 largest cities in the US according to the average frequency of auto collisions and resulting claims. In the 2010 study, Fort Collins, Colorado, was ranked as the safest city, with the average driver experiencing one auto collision every 14.5 years. The least safe city was Washington, DC, with the average driver experiencing one auto collision every 5.1 years. The average frequency for all cities was 10.0 years.

Based on your particular characteristics, your location and your car, together with your actual history of auto insurance claims, you could make a reasonable assessment of how often you could be expected to make an auto insurance claim in the future. Using that frequency, you can decide the optimal deductible to choose for your auto insurance policy. Remember, the shorter the break even period, the better.