Deductible Aversion (Insuring the Small Stuff)

Insurance: Don’t Sweat the Small Stuff

There was a popular self-help book with the title Don’t Sweat the Small Stuff . . . and It’s All Small Stuff. The book’s sensible message was that we should not get obsessed with minor annoyances that, in and of themselves, are not really a big deal. This is certainly good advice that applies in nearly every aspect of our lives. (Even coauthors who have worked together for decades sometimes forget this point.) Although that book is about emotional well-being rather than financial planning, the title serves as an excellent guide to insurance purchases.

Economists agree about the right way to think about insurance. The most important principle is to get protection against rare but significant mishaps that can lead to financial ruin. The sorts of risks that should be insured are homes being destroyed by floods or fires, major health problems, the death or disability of a family income earner, and the crash of the family car (if it is still worth anything). Any of these events can put a household in debt for years, or even lead to bankruptcy. Paying a company to share those risks makes good sense. We should not be insuring against the possibility that our team will lose the championship game, that our coffee machine dies, or even that we dent our car backing into a parking spot at night.

Of course, what constitutes a “large” loss will depend on one’s financial situation. A loss that a wealthy household can absorb may create serious hardship for a poorer one. But the key principle remains the same. “Don’t insure the small stuff” is really good advice, but people do not seem to follow it. In fact, people sometimes fail to insure the big stuff! Those living on a floodplain often fail to purchase insurance against a flood and can be wiped out by a severe flood. These losses are tragic. The concern here is at the other end of the loss spectrum: paying premiums to insure losses the household could afford itself.

The earliest forms of insurance did cover the sorts of risks that are sensible to insure. Merchants would buy insurance to cover the risk that a sailing ship would not return with its cargo for whatever reason. Fire insurance became common after the Great Fire of London in 1666. Mortgage lenders now require homeowners to have property insurance to make sure that the bank’s collateral does not go up in smoke. Because insurance contracts can be complicated and crammed with fine print, you will not be surprised to learn that Humans often stumble when they have to choose which policy to buy. And you will be even less surprised to find out that we think some improvements in choice architecture can help here, too.

Even if you have paid off your mortgage, it is completely sensible for you to have an insurance policy that will protect you in case your home is destroyed by a fire or damaged by a storm. For many families, their home is the most valuable asset they own, and you should make sure that your policy would cover the replacement cost of your home (not the land) in case of a total loss. However, homeowners insurance policies, like many other kinds of insurance, are usually sold with a deductible, which is the portion of any loss that the policyholder has to pay. It is important to understand how deductibles work, because choosing the wrong deductible is the single most common mistake consumers make in purchasing any kind of insurance. Our rule of thumb is: when purchasing insurance, consider the largest deductible you could afford to pay without serious hardship.

Of course, there are exceptions to any rule of thumb, including this one. If you are offered a deductible so large that paying it would cause a serious financial hardship, a lower one may be appropriate. But in general, people choose a deductible that is too low. In fact, we have a name for this mistake: deductible aversion.