Deductibles serve both insurer and insured

There's good sense behind the insurance policy deductible; local government risk management policies can include various types and sizes

By Michael Kelly
Risk Management Director

The application and utilization of "deductibles" are common in many different types of insurance policy forms – property/casualty and health. Stated simply, a deductible is a portion of a loss that is covered in the policy but must be paid or handled by the insured, not the insurance carrier.

The first question someone might ask is why an insurance company and their insured would want to use a deductible in the first place. The reasons are that deductibles serve as a risk financing technique that help contain cost by eliminating the necessity of the insurance company to process small losses, which drive up operational costs and, by extension, increase insurance premiums.

Secondly, by essentially guaranteeing that the insured will participate in each loss, it reduces morale and moral hazard issues as well, while simultaneously encouraging loss control efforts from the insured. As a review, a morale hazard is where an insured takes an "I don't care" attitude in loss prevention because he or she is simply expecting their insurance to take care of the loss. A moral hazard is due to an insured's poor ethics, such as turning in a false or inflated claim just to get the insurance claim money.

With the use of a deductible, smaller losses are handled by the insured, and their claims experience will be reflected in their premiums. Most insureds will not turn in a first-party claim (for damage to property that they own) that is going to definitely fall below their deductible amount. This reduces both the frequency and severity totals in your experience. (As a side note, it is never a good idea to refrain from turning in a third-party claim even if it appears to be insignificant – as it is much more difficult to predict the total loss – or if it will ultimately be litigated.)

Let's look at the principal types of deductible clauses that are utilized today. The most prevalent is a straight deductible, which is typically found in property line insurance polices, i.e. buildings, contents and related mobile or inland marine equipment policy forms. The deductible is expressed as a specific amount and applies for each loss regardless of the number or amount of losses. An example would be a $1,000 per occurrence automobile collision deductible. For each collision, you as the insured would be responsible for the first $1,000 of loss for damage to the vehicle. Any amount of damage above this $1,000 would be paid and borne entirely by the insurance company.

A per event deductible is often utilized to address damage claims arising out of a single event, such as a named storm or hurricane. These types of deductibles typically apply to each event, or even each item, such as a building or each location. As such, there is a cumulative effect with the possibility that a large number of items damaged may ultimately result in a substantial amount of retained loss for you as the insured.

As referenced in the per event deductible detail, not all insurance policy forms utilize deductibles as dollar amounts. Some may employ a percentage deductible, which is based on some other amount, such as the total amount of insurance, the total amount of the item insured (building, contents, etc.) or the total amount of the loss. As a result, just as these insurance values increase in size, so will the total dollar amount of percentage deductible increase proportionally.

Typically, "for profit" insurance carriers will mandate a minimum "named storm" per event deductible expressed as a percentage (minimum of 2 percent up to 5 percent) of each building's replacement cost value total for counties that are located on or near North Carolina's coastline.

Aggregate deductibles are an amount to be paid by the insured for all losses sustained during a specific period of time – typically one year – and are sold in dollar increments. They are designed to establish a maximum total that an insured is responsible for regardless of the frequency or severity of losses. They minimize the effect of sustaining a large number of smaller losses because their total accumulates. Through accumulation of all losses, after the aggregate amount is reached during a single policy year, the insured no longer participates in future losses – even if they are smaller than the per occurrence straight deductible.

For business interruption type losses (loss of income arising separately from a covered loss), a time deductible is often used. This is not expressed as an amount of money or percentage but instead as a specific length of time that must pass before coverage actually begins. Another example might be that 48 hours must pass before a personal automobile policy will allow reimbursement for the leasing of a substitute car.

One of the less common deductible types used is the franchise deductible. This differs from the straight deductible in that should a loss exceed the franchise (typically an amount 2 percent or 3 percent of the total insured value), the insurance carrier pays the entire amount of the loss. As an example, a shipment with a total value of $100,000 with a 2 percent franchise deductible sustains a loss of $1,500. The insurance carrier pays nothing, but if the amount of loss were $3,000, the full $3,000 is paid to the insured. In this example, as long as the franchise amount of $2,000 is reached, the entire loss is paid by the insurance carrier.

There are still more rare deductible types available, such as convertible, cumulative and progressively diminishing deductible forms, but these are not typically utilized in insuring local government exposures and are omitted for clarity and column space. Using deductibles of any type help prevent what is essentially known as dollar trading, in that the insured pays the insurance company premiums that cover small losses and the insurance company then basically pays these same dollars back to the insured.

Deductibles are not a panacea to lower insurance costs. Weighing the credits generated against the total premium is important. Always remember one of the most basic risk management tenets discussed earlier: never risk a lot for a little. In other words, use deductibles where it makes good sense and is cost effective. The return needs to reflect the additional responsibility you are assuming by the selection of deductible type and size.

NCACC Risk Management Director Michael Kelly writes a regular column on risk management for CountyLines. With more than 32 years of risk management/insurance experience, he holds the Associate in Risk Management for Public Entities, Certified Risk Manager and Certified Insurance Counselor professional designations. He can be reached at michael.kelly@ncacc.org or (919) 719-1124. Archived versions of the column can be found online at www.ncacc.org/managingyourrisk.html.