Insurance is a transfer of risk. In exchange for paying premiums, the insurance company takes on some of the risk that we otherwise would experience during an adverse event. But rarely does the provider cover 100% of the risk. Oftentimes, we have a deductible to pay in such an event. And we have to cover that out-of-pocket.
As a part of a holistic financial plan, insurance deductibles ought to be coordinated with the emergency fund. Having this liquid cash on hand in the event of a hardship ensures that we can cover the deductible and any other upfront expenses.
Let’s discuss how these things work and how you can adequately prepare your emergency fund and policy coverages.
What is a Deductible?
Simply put, a deductible is the portion that we as the policyholder are required to pay in the event of a covered incident. This portion represents the amount of responsibility (risk) that we take on versus what the insurance company takes on.
There is usually a deductible in home, renter, auto, and health insurance policies. Each type of variable depends on the policy type and the incidents covered.
Let’s say we have an auto policy with collision coverage and under which there is a crash. The amount the driver will have to pay depends on what he or she has selected in the policy.
So if the deductible is $1,000, the first $1,000 of expenses comes out of pocket, and the insurance covers the rest. A $5,000 covered incident with a $1,000 deductible means $1,000 paid out by the insured and $4,000 paid out by the insurance company.
But a lower deductible causes coverage to kick in earlier. In the same example, but with a $500 deductible, the insured pays $500 and the insurance company pays $4,500.
Keep in mind that if a given incident does not exceed your deductible, the insurance company does not get involved at all. That means a $900 repair with a $1,000 deductible has to be paid entirely out of pocket.
How Does the Deductible Affect Premiums?
Generally, if you increase your deductible, your premiums will go down. That’s because a higher deductible means less risk the insurance company is taking on.
And if you decrease your deducible, premiums tend to increase. So it’s important to make sure that both your budget and emergency fund are prepared to handle this responsibility.
On the other hand, your premiums are also a reflection of your insurance claim history. The more claims you have, the higher your premiums tend to be. Raising the deductible can be one way to counteract this if you have a significant number of claims on your record.
How the Emergency Fund Fits into Things
We don’t know when an adverse event will happen to us. But it certainly will at some point. That’s why we need to prepare. A critical part of financial preparation is to have an emergency fund.
While you are paying off consumer debt, I recommend having a starter emergency fund. This is a small amount on hand to cover the likely events that could happen on your debt free journey.
Once you have paid off your consumer debt, I recommend having a fully-funded emergency fund of 3-6 months’ worth of expenses.
For the starter emergency fund, I suggest somewhere around $1,000-2,500. While this wouldn’t cover an HVAC replacement, it would cover your insurance deductible most of the time.
If you don’t have an emergency fund, the fallback is often using a credit card to cover the deductible. And if you’re already working on paying off debt, adding to the balances won’t help.
That’s especially since credit cards have obscenely high interest rates. As of early August, 2023, the average credit card interest rate is 20.97%. (Can you imagine earning that in your retirement account?).
As a personal example, in 2021 we had a crash where we had to pay the deductible. Thankfully it was only $500, but we had that cash on hand to cover the out-of-pocket expense to get the car repaired.
The nice thing was that since it was the other driver’s fault, our insurance company reimbursed the deductible to us and pursed the driver for the repair costs including our deductible.
Talk to your insurance agent to see how this process may look like with your policy.
Should I Raise My Deductible?
A higher deductible can have multiple benefits. But it’s important to consider if this is right for you.
Adam Forsberg is an insurance agent with Liberty Mutual based in Fredericksburg, VA. He is licensed in nine states and the District of Columbia. On the deductible topic, he recently shared some wisdom as a trusted expert.
“Since the deductible is the amount they are responsible for out of pocket in the event of a claim, I work with my customers to make sure they have a deductible they’re comfortable with.”
He says that there are three things that he considers when working with a customer on tailoring their policy. In these situations, a higher deductible can make sense.
- In this current insurance market, companies have been pickier about offering policies. Some will not offer coverage at all, unless the customer is willing to take on a higher deductible. Raising the deductibles opens up more companies I can shop with.
- Having a higher deductible will bring the cost of the policy down.
- A higher deductible will encourage the customer to not file small claims. Filing several small claims can cause significant rate increases at renewal, or even cause the company to not offer another policy next year.
To determine what the best choice is for you, contact an agent or broker licensed in your state.
Final Thoughts on Deductibles and the Emergency Fund
Having good insurance policies in place protects your wealth and wealth-building ability. Make sure that you have adequate coverage in place for auto, home/renter, health, life, and identity theft. I discuss these types of policies more in this article.
Insurance has an opportunity cost. And it can be an annoyance to budget for it throughout our lives and not need it that often.
But when adversity comes, we will be very grateful we took the time to have these policies in place. The juice is well worth the squeeze.
To discuss your overall financial picture and how you can achieve financial freedom, book your free Discovery Session today!
