One reason not to buy homeowner’s, flood, or earthquake insurance

Posted by Tatyana Deryugina on Dec 8, 2011

Filed Under (Environmental Policy)

A frequent claim about homeowner’s, flood, and earthquake insurance (I will use the term “home insurance” for short) is that not enough people have it and those who do don’t have enough of it. Lots of explanations have been put forward, ranging from underestimation of risks to expectations of government aid. But there is at least one more (rarely discussed) rational reason for some US residents to not buy home insurance – the US tax code.

You cannot deduct home insurance premiums from your taxes. The legislators probably figured that it’s a purchase like any other, so why should you be able to get a break for buying it (let’s forget about the deductions for having children and a mortgage for a second)? However, you can deduct disaster-related losses from your taxes. Again, that may be a reasonable rule on its own – we can think of the loss as a loss of income that you had at some point.

When you put these two things together, you get a real disincentive to buy comprehensive insurance. In some cases, homeowners can even deduct losses from past tax returns and get those taxes back. I’m not going to claim that this means people should have no insurance. But for most people, it will make sense to have a fairly high deductible. To clarify, a fairly high deductible (as much as the homeowner can comfortably afford) is already recommended by most experts based on insurance prices, but my claim is that people should choose a deductible that’s even higher.

Here’s a numerical example. Suppose that your taxable income has been $50,000 a year for the past three years and your federal income tax rate is 10% (or $5,000). You own a $200,000 home that’s located in a flood plain. For simplicity, let’s say the only risk is a 1% annual chance of $100,000 damage to your home. Actuarially fair insurance would then cost $1,000 per year. So if you buy insurance, you pay $1,000 per year for certain but don’t have to suffer any losses.

Now suppose you choose not to buy insurance and you suffer the loss. You can deduct it from your tax returns for this year and next year (or even last year in some cases), which would get you $10,000 of that loss back. So it’s as if you only lost $90,000. Of course, that’s still a lot of money, but now that actuarially fair insurance looks like it has a load factor of 0.9. And, by the way, you probably can’t get actuarially fair insurance in the first place.

Finally, suppose you can get a loan to repair your home. You borrow $90,000 (because you got $10,000 from the government) at 5% interest for 5 years. According to a handy online mortgage calculator, the monthly payments for that kind of loan will be $1,698.41 and this loan will cost you $101,904.66. Not bad, considering you didn’t have to pay premiums for all those years.

To summarize, if the interest rate that you can get is low enough and you’re young enough, you may be better off buying insurance with a very high deductible (or foregoing it altogether), deducting the resulting losses from your taxes, and getting a loan to repair the damage. Of course, bigger losses will make insurance more appealing, but if the loss is moderate relative to your income, absorbing it shouldn’t be that hard. And if I were an insurance company, I would campaign hard to make insurance payments tax-deductible.