We all know you can arrange a higher deductible (USA) or excess (UK) to pay a lower insurance premium.

My question is, is there an established method to identify what is the optimal size of deductible?

  • 1
    As high as you can afford? – cbeleites Mar 21 at 0:16
  • Here is an illustration. Our company insurance has excess set at £100 and we keep £10K in emergency cash. We also have a policy of covering claims as expenses, to avoid our premiums increasing. I asked, why don't we increase the excess to £1000 and save money? And the answer was "if we have ten claims for £1000 in a year, the company's savings would be wiped out!". The justification strikes me as illogical, but I lack the knowledge to evaluate it critically. – Douglas Held Mar 21 at 11:19
  • Do you have knowledge of the claims history? – quid May 24 at 14:33
  • Yes. We typically have about £1000 in claims each year, which we pay as expenses so as not to increase the premiums. – Douglas Held May 24 at 19:17

You have to take two things into account when considering how much you should spend on insurance: frequency of claims (how often they happen) and severity (how bad any given claim is likely to be); this is how your insurance company looks at it as well: Ideally, you want to purchase insurance for the unexpected (low frequency, high severity) because that is the least predictable risk, and take on the low severity and higher frequency losses because these are the most predictable and the insurance company is just going to charge you for it anyway.

As an (extreme and simple) example, let's say that you have had $1,000 worth of losses every year for the last 5 years and you have policy with a zero deductible - your premium is going to be at least $1,000 plus the cost to insure losses above $1,000 to the limit of insurance; therefore, if you know that you'll have at least $1,000 worth of losses you should have a deductible of at least $1,000 because then you're reducing the dollar swapping between you and the insurance company (and you actually pay more than $1,000 due to transaction costs). This can be calculated by taking all of your losses you have, indexing them for inflation to present value, and then dividing by the number of years they cover - Ins. Cos. usually use 5-7 years.

In your example, if you are paying for the $100 deductible and have $1,000 worth of losses and just not reporting them, you are overpaying because deductibles are supposed to reduce the FREQUENCY of losses, not SEVERITY. You are just reducing the severity of a very infrequent event (a large loss) when you could just put that money in your pocket and pay for the loss when it happens - because, again, the insurance company is just charging you for that + transaction costs.

With respect to the idea that 10 claims will put the company out of business, so will 30, 40, or 1,000,000 - but how likely is it and how much premium will you save if you increase your the deductible? If it's not likely and you save a lot of premium, the decision is simple.

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