March 30, 2015

Should You Allow Damage Insurance in Place of a Security Deposit?

security deposit

I own a vacation condo on Lake Erie, just outside the town of Geneva-on-the-Lake, Ohio. Like half of the people who own apartments in the building, we rent out the property on a short-term basis when we are not using it.

If you rent property to someone else, you face the possibility that the person renting will damage it. That means that I, like the many people around the world who now rent properties online through sites like Vacation Rental by Owner (VRBO), Owner Direct and Flip Key, face an important decision about how to protect themselves from losses from renter-caused property damage: require a security deposit or ask renters to purchase damage insurance?

Damage Insurance Versus Security Deposit

The field of economics has a very clear answer to this question. When you rent property to someone else, there is asymmetric information. Because the owner does not know how well the renter will treat the property, charging a security deposit is a good idea. Renters will have an incentive to take care of the property to recoup their security deposit. If you are renting a condo for the weekend and you have paid a $500 refundable security deposit, you’ll think twice about having a wild party or leaving your kids unsupervised – one broken table could double the cost of your stay.

However, many of the vacation rental websites offer damage insurance as an alternative to a security deposit. For a $49 fee, Homeaway, for example, offers $5,000 worth of damage protection to short term renters of vacation properties.

In my condo building, several of the owners allow renters to purchase damage insurance instead of paying a security deposit. Their reasoning is that the insurance provides more damage protection. If a renter causes $4,500 worth of damage to their condo, they may be able to recoup all of their loss from the insurance company, but if they take a $500 security deposit, they know they can only recoup up to $500 worth of damage from yhose funds. Moreover, because the decision to return the security deposit resides with the homeowner, some potential renters balk at putting up $500 against damage for a stay of similar cost.

As an economist, I am surprised by my neighbors’ approach. With insurance, the owner is giving up the right to decide the validity of damage claims. If you’ve collected a security deposit and someone breaks a television, you can just deduct the cost from the security deposit, which is already in your possession. If you go the route of insurance, however, you run the risk that the insurance company will decide that the renter wasn’t responsible for the damage and won’t pay the claim.

More importantly, the choice of a security deposit or insurance demonstrates a classic moral hazard problem. Moral hazard is the idea that people will take more risks if they don’t bear the costs of their actions. For example, if you have a security deposit you want back, you will be more likely to tell your kids not to use the table in the living room as a piece of gymnastics equipment than if you have paid for insurance that covers damage resulting from their gymnastics show.

Over the years of writing for Small Business Trends, I have learned that many people who read my posts know a lot about the topics I discuss. Therefore, I am sure there are many readers who have a lot of experience with the damage insurance question.

So tell me and the other readers of this column: If you were renting out a vacation condo, would you insist on a security deposit or would you allow renters to purchase damage insurance instead?

Jumping Photo via Shutterstock


Scott Shane

Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

6 Reactions

  1. Insurance sounds better in theory. Of course, it’s all in the fine print, don’t you agree? Will an agent inspect the property before a renter stays there each time? Seems to be the only way it would work – in theory.

  2. I prefer a damage deposit for my rental, though the industry seems to be trending towards insurance.

    Another factor to consider in the decision is that withholding a damage deposit can often result in a combative response by a renter, which could include a negative review, which could have a far greater cost to you over time.

    Depending on how many existing (positive) reviews you have, a negative review could be far more expensive. You may be faced with the decision of whether or not to withhold a $500 damage deposit to fix that TV, when doing so might also cost you tens of thousands in lost rental revenue due to a bad review.

    I still prefer a damage deposit due to the misalignment of interests that insurance brings, but I just don’t think withholding the damage deposit is always that easy, and that needs to be factored into the decision, as well.

  3. From the business perspective (renting out the property) the best idea might be to follow the market. In other words, accept either a security deposit or evidence of Property Damage Protection, as the customer prefers. While some renters may balk at putting up $500, they should accept the requirement for a low cost Property Damage Protection product and may indeed welcome the protection it affords them. Meanwhile, many renters would entirely expect to pay a security deposit and balk at the idea of being ‘forced’ to purchase an insurance product at added vacation expense. The Landlord’s decision here might also consider the demand for the particular rental property in question.

  4. Security deposits are limiting. But then you’ll always have the money in case the renter said that they want to leave your house. We use it to cover the blank months. An insurance, on the other hand, will not be able to make us do that. While it can cover the damages, we will not be able to use the money for other purposes.

  5. This is an interesting article with issues to consider. I just bought a condo, to be ready by 2018, with plans to rent out for rental income, instead of earning lower interests from fixed deposits.

  6. I am a owner of a vacation rental and have used damage insurance for years. It always seemed so much more convenient. That is until a guest damaged my property. She told the insurance company that she didn’t do it, and the claim was denied. So basically the insurance is protection only with honest guest who you have good rapport with. But those aren’t the ones who damage your property

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