The concept behind property and casualty (P&C) insurance is straight forward. Consumers pay a premium for insurance coverage and, should they incur a loss greater than their deductible, they can file a claim for the balance. However, when we consider the fact that insurance companies operating in bonus-malus systems typically raise a customer’s premium after they submit a claim, the question of whether the insured should submit a claim versus paying for the loss out of pocket becomes substantially more complex.
This internal tension when deciding whether to file a claim or not leads to what is known as a “pseudo-deductible” – referring to the true dollar amount of a loss one would need to experience before deciding to actually make a claim (above and beyond just the stated deductible itself). In this guest post, Dr. Derek Tharp – a Kitces.com Researcher, and a recent Ph.D. graduate from the financial planning program at Kansas State University – takes a closer look at this underexamined phenomena, including why the conventional wisdom to take as large of a deductible as one can afford may not be quite right (and why consumers should actually identify their ideal pseudo-deductible first).
The decision of how large of a pseudo-deductible to adopt is naturally influenced by many factors unique to an individual (e.g., our aversion to risk and uncertainty, as well as our ability to withstand loss in the first place). Though we cannot “solve” for an ideal pseudo-deductible in an algebraic sense, one method we can use to inform the question of how large of a pseudo-deductible may be ideal is Monte Carlo simulation based on real-world assumptions. Using national claims figures combined with peril-specific premium increases (as the premium increase for a loss which could indicate negligence or risky behavior is often higher than one that is completely out of an insured’s control, such as a natural disaster), the results of this analysis indicate that, in isolation, an ideal pseudo-deductible for homeowners insurance policy could be somewhere in the range of $500 to $1,500.
Of course, this amount is by no means fixed and is everchanging as both consumers and insurers adjust to the behavior of one another. But the key point is that by adopting some non-trivial pseudo-deductible above and beyond one’s deductible, it is possible to reduce both long-term average costs and outcome variability. Yet, if those adhering to conventional wisdom truly adopt deductibles “as high as they can afford”, this may not put them in a position to strategically forgo claims that may increase long-term costs. Instead, consumers may wish to first identify the maximum pseudo-deductible they can afford to adopt (or wish to adopt given their risk preferences) and then select a lower deductible which allows them to strategically forgo claims that may result in higher costs in the long run (but not a deductible that’s too much lower, or consumers are paying a higher premium for a lower deductible threshold they won’t use anyway given their higher pseudodeductible).
Financial advisors can lend a hand by helping clients understand these dynamics, as well as helping clients develop a better understanding of the actual odds that they will incur a loss (versus their preconceived notions of those odds). In fact, when participants in an experimental study were given information about the likelihood of a hypothetical loss reoccurring, they increased their pseudo-deductibles (but not their deductibles!) to levels which more effectively balanced the long-term costs and benefits of filing a claim – suggesting that this type of assistance can truly be beneficial to clients. Ultimately, though, the reality is simply that “the highest deductible you can afford” is not necessarily best; instead, your pseudo-deductible should be the highest you can afford (and are comfortable taking the risk), and the optimal deductible should be somewhat lower.