If you are like me you pay your insurance and forget about it. This article is about how to avoid that sinking feeling when your insurance agent says your loss is not covered under your homeowners policy. What you may not realize is that insurance companies exclude, or partially exclude, entire classes of losses. These fall into two main categories : correlated risk and moral hazard.
What insurance companies are afraid of paying for is really big catastrophes. If my house burns down that is catastrophic for me, but it is unlikely to affect the whole city. Since it hard to actuarially adjust the premiums for really big losses that happen infrequently, the companies tend to exclude them.
War is one example. Hurricanes are another. My homeowners policy states that flood damage is an exclusion “regardless of how caused” and goes on to state that flood includes “but is not limited to storm surge, waves, tidal water, overflow of a body of water, whether driven by wind or not.” Whew! If you want protection from flood loss get a flood insurance policy which is a government program.
Another factor to consider is that most policies in costal areas of the country now include enhanced deductibles for “Named Storm Damage” (Hats off to the storm-naming National Weather Service). Unlike a standard deductible which is a fixed dollar amount, the hurricane deductible is based on a percentage of the total insured dwelling value
So far we have been discussing correlated risk – multiple losses that can happen together. Another type of loss that insurance companies try to steer away from is moral hazard. Moral hazard is when the insured’s behavior changes in such ways as to raise the costs for the insurer.
But you might say, “all insurance affects behavior.” That is almost the point of insurance. If my camera is insured, you bet I’ll be more likely to take it on a canoe trip over the rapids. What the companies are concerned about are the hidden moral hazards, where having the insurance will be encouraging indifference. “Yes,” the company says we insure against loss, “but we don’t want to be ridiculous about it.”
Infestations of vermin are not covered. You really should wash the dishes in the sink and keep your house tidy. Mold is not covered. Fix that roof leak. If a bowling ball falls off your shelf and breaks your TV, shame on you.
To learn more about these questions check this National Public Radio Planet Money report.