Bajtelsmit Column: Don’t Insure the Small Stuff

Note to Editors: Vickie Bajtelsmit is a finance professor in the Colorado State University College of Business and the author of three personal finance books.

We’re all feeling the pinch of rising costs this summer. Government statistics tell us that inflation is hovering around 4 percent, only a little higher than its long run average. Somehow, it feels like prices have increased a lot more than that.

For some households, particularly those with less fuel efficient cars, expenditures are way higher than last year. For example, at $4 a gallon, the gasoline component of a household budget is up more than 30 percent compared to last summer.

With an economic climate where incomes are rising at a slower rate than the prices of goods and services, it’s important to carefully examine your household budget for any areas that can be trimmed.  I suggest that you take a closer look at your insurance policies.

Many people make the mistake of buying insurance with low deductibles.  A deductible is the amount of a loss claim that you must pay before the insurance company is responsible to pay anything. Insurers usually offer menus of policies for auto, homeowners, and health insurance, with lower annual premiums for policies with higher deductibles.

It may seem counterintuitive to increase your deductible. After all, if you experience a loss, you want the insurance company to pay as much of it as possible, right?

Well, actually, no. A general rule of thumb for insurance is that you should never insure against losses you can easily budget for. Predictable medical costs, for example, should be budgeted, not insured. In the end, you’ll pay less out of pocket for the year, when you consider the extra premium costs for a low deductible policy.

As an example, let’s compare two health insurance policies. Assume identical coverage except one has a $1,000 deductible and the other a $250 deductible.  Beyond the deductible, the insurer pays 90 percent.  Insurance companies calculate your premium by taking expected annual claims payments and adding on for their administrative costs and profit.

If your annual losses are $600, you’ll pay the whole $600 in the first case and $285 for the second ($250 deductible + 10 percent of $350 remaining).  But the annual premium savings for the $1,000 deductible might be enough to offset the out of pocket difference due to the deductible.  This is because the cost of administering those small claims is often at least as much as the claims themselves. For example, think of the time it takes for the insurance company to process a $50 office visit, generate the paperwork for you and the check for the doctor’s office.

For auto and homeowners insurance, it’s even more important to take a high deductible. This is because claim frequency will increase your future premiums and may even result in policy cancellation. So reporting small claims to your insurer is usually a bad idea.  If you don’t plan to report anything under $1000, you certainly don’t want to opt for the more expensive policy with a $250 deductible.  You’d be paying more and getting nothing in return.

How much you can save by increasing your deductibles will depend on the type of insurance and other risk factors. For example, in a typical year, most people don’t make any claims on their auto or homeowners, so whatever they save in premium is a net gain. Certain health-related costs can be expected to occur annually, so can easily be budgeted for instead of paid to the insurer with extra charges for expenses and profit.

Hopefully, your premium savings will be enough to pay for a few tanks of gasoline.