Just as certain expenses are deductible on your tax return, most all insurance policies include a specific provision, specifying an amount of money deductible, by the insurance carrier, from the payment of a claim. Now, unlike most things in insurance and legal circles, we actually call this item what it is, the deductible. The word “deductible” is defined in Barron’s Dictionary of Insurance Terms as “an amount of loss that insured pays in a claim.” Basically, the insurance carrier agrees to provide a policy holder with coverage up to a certain limit, provided the policy holder agrees to pay premium and accept a portion of a covered loss equal to a deductible. While deductibles can be included on any policy type, our discussion will center on applying them to earthquake insurance.

A deductible on an earthquake policy works as a layer of coverage. The insured pays the first layer and the insurance company is responsible for amounts in excess of that first layer. The amount in the first layer is typically a percentage of the building replacement cost. If a deductible is 20% of the building replacement cost, and the building would cost $1,000,000 to replace, then the insured would be responsible for $200,000 of the loss. It is important to note that a deductible is not a percentage of the amount of damage done to a building. It is a percentage of the buildings overall replacement cost, regardless of the damage done.

There are many ways an insurance carrier could write their deductible provision. Most common are as a percentage of the total insurable value of the association or as a percentage of the value of each building. We will look at each one, as would be applied to the same association. Here are the characteristics of our risk:

Perfectly Structurally Sound Homeowners Association

This Association is composed of 5 buildings with 10 units in each building. All buildings are the same size and shape, and each would cost $2,000,000 to replace if totally destroyed (that is the building replacement cost). The total insurable value of the association is $10,000,000 ($2,000,000 per building x 5 buildings). The Association has in place an insurance policy with a $10,000,000 policy limit and a 20% deductible. The association sustains damage in an earthquake in the following amounts:

Building	Replacement Cost	Repair Cost
1	$2,000,000	$200,000
2	$2,000,000	$500,000
3	$2,000,000	$500,000
4	$2,000,000	$1,000,000
5	$2,000,000	$1,000,000

Example 1 – Deductible Applied to the Total Insurable Value of the Association

The total insurable value is $10,000,000, and the deductible provision is 20% of that value, therefore the deductible is $2,000,000. In the loss sustained, the total cost of repairs is $3,200,000. Because the Association pays the first layer of coverage (the deductible), the Association would be responsible for $2,000,000 and the insurance company would pay $1,200,000.

Example 2 – Deductible Applied to the Replacement cost of Each Building

This can be a bit trickier, so we will take it step by step. Each building deductible is 20% of its replacement cost, or $400,000. Instead of needing to sustain a total loss of $2,000,000 over all of the buildings before insurance is used, there could be as little as $400,001 damage to one building and the Association could see payment from the carrier. Using the same example as before, here is how the deductible layer and the carrier involvement would break out:

Building	Replacement Cost	Repair Cost	Deductible Amount	Association Pays 1*	Carrier Pays 2*
1	$2,000,000	$200,000	$400,000	$200,000	$0
2	$2,000,000	$500,000	$400,000	$400,000	$100,000
3	$2,000,000	$500,000	$400,000	$400,000	$100,000
4	$2,000,000	$1,000,000	$400,000	$400,000	$600,000
5	$2,000,000	$1,000,000	$400,000	$400,000	$600,000

1*-Association pays the amount of the deductible or the repair cost, whichever is less

2*-The carrier pays the repair cost less what the association pays

The total loss is still $3.2 million. The total expense to the Association in this example (deductible layer) is $1,800,000, and the insurance carrier would pay $1,400,000.

There are pros and cons to each of the ways a carrier may apply its deductible provision. The main differences are the cost of the insurance and the chance of using the coverage. In Example 1, because the exposure to the Association is higher, the insurance cost is lower. The trade off is that the Association would have to sustain a larger loss to gain access to the insurance. In Example two, there could be as little as $400,001 of damage to just one building, and the carrier would be paying out. This lower exposure to the insured leads to higher premium.

But let’s look at the actual realized difference in the cost. Assume the policy in Example 1 costs $10,000 per year, and the policy in Example 2 costs $25,000. The savings on premium to the Association is $15,000 per year, and the additional exposure is $1,600,000 in Example 1. In order to off-set the additional exposure, over 100 years would need to elapse without the occurrence of an earthquake. That, some would say, is quite a long time for no earthquake to occur in Southern California, to say nothing of the constantly fluctuating market for earthquake insurance.

Earthquake Insurance is a unique insurance animal. Because the insurance isn’t mandatory in the State of California, associations should consider working with an insurance professional to design a program for earthquake insurance on the community property. You may be surprised at the ways policies can be written, affordiably, to provide protection for the membership.

Michael Berg is the Director of Operations for Berg Insurance Agency