Why Do Insurance Policies Have Deductibles?

Why Do Insurance Policies Have Deductibles?

Why Do Insurance Policies Have Deductibles?
Reading Time: 5 mins

Deductibles have been—and still are—an important term in insurance policy fine print. Understanding the role deductibles play when purchasing car insurance, health insurance, home insurance, or business insurance is crucial to getting the most out of any insurance policy.

Simply put, insurance deductibles are the out-of-pocket expenses that you must pay before your insurance coverage starts and pays out your covered claim. The actual deductible value will vary based on the insurer, scope of coverage, and how much you pay in premiums. As a general rule, you can expect to pay lower monthly or annual premiums if your policy comes with a high deductible simply because you cover more costs before your coverage kicks in.  

Today, we examine why insurance policies have deductibles, explain how insurance deductibles work, and delve more deeply into the relationship between insurance deductibles and premiums.

What Are Deductibles?

A deductible is the amount of money that you, the policyholder, must pay toward an insured claim. Your insurer subtracts your deductible from the total claim payout when you experience a disaster or covered loss. Deductibles are a way of sharing the risk between you as the policyholder and your insurance carrier. As noted above, the higher the deductible, the less you’ll pay in insurance premiums. The reverse applies with lower deductibles.

Your insurance provider may quote your deductible as either a specific dollar amount or a percentage of the total amount of your coverage. This amount is usually dictated by the terms of your coverage and will often appear on the declarations page of your insurance policy documentation. 

Why Insurance Policies Have Deductibles

Deductibles are a form of risk sharing between insurance providers and their customers. In this case, the deductible is the share of an insurance claim that you must cover before your insurance company meets its financial obligations. From a policyholder perspective, deductibles help keep insurance costs at a reasonable level. But why do insurance providers use deductibles?

Moral Hazard

Very few beliefs are as deeply rooted in contemporary insurance as the fact that a deductible provision in an insurance policy provides a significant safety net against moral hazard. Our experts look at moral hazard as the relaxation of the standard precautions that result from insurance protection. The result is that an insurance company stands a higher chance of loss resulting from a policyholder’s tendency to deviate from generally accepted safety standards.

For instance, the availability of dental insurance may lead you to be less prudent about your oral hygiene, which translates to a higher probability of moral hazard. Similarly, a driver carrying auto insurance may have the incentive to drive recklessly or park their vehicle in a dangerous area because they are insured against damage and theft. 

To mitigate such risks, an insurance deductible ensures that you’re responsible for part of the claim costs, so you’ll likely exercise greater caution. The insurance company aligns its interests with yours, and you both work toward mitigating the risk of a disastrous loss. 

Reduction of Claims

Without a deductible on a policy, an individual could easily file a claim for a $30 dent repair on their car’s bumper. After all, who cares, right? It’s only thirty bucks… pay it. Well, your insurance carrier isn’t on the hook for only $30; the total cost of investigating and paying out your claim will exceed that $30 by a long shot. For example, both the insurance representative who takes your claim over the phone and the claims adjuster are paid salaries.

Your insurance company places a deductible on your policy to prevent you from making insurance claims that are so small that you can reasonably bear the cost on your own. Ultimately, it’s all for the insurance carrier’s benefit, since deductibles ensure the insurer won’t pay out every single claim, which leads to increased savings.

How Do Deductibles Work?

When you suffer a loss such as damage to your vehicle or make an insured claim, an insurance adjuster will investigate the incident. Part of the process involves determining how much your insurer will pay to fix the damaged car or settle the claim. And here’s where an insurance deductible enters the scene.

For a dollar amount standard deductible, a specific amount of money would come off your claim payout. For instance, if your claims adjuster estimates a damage payment of $5,000 and the policy states a $1,000 deductible, you’ll need to pay the $1,000 before your insurer pays out the remaining $4,000 of the claim.

Percentage deductibles are only relevant to homeowner insurance and are usually calculated based on a fraction of your home’s insured value. If your home is insured for $200,000 and your policy states a 4% deductible, $8,000 will be deducted from any claim payout. With auto or homeowner insurance, deductibles apply every time you file a claim.

What Determines Your Deductible Amount?

The final amount of the deductible is usually a joint decision between you as the policyholder and the insurance provider. With some policies, your insurance provider will set a minimum deductible and then offer higher deductibles as options from which you can choose. For instance, a standard homeowner insurance policy may stipulate a $1,000 minimum deductible. However, you could choose a $2,000, $3,000, or up to a $5,000 deductible to save money. The higher your deductible, the greater the risk you assume, but the less you’ll pay in premiums. 

When choosing a deductible amount, be confident that you’ll have enough funds to cover the amount of your deductible in the event of a loss. Some will trade off paying a higher premium for better coverage against being without their car for weeks because they can’t cover their deductible. After all, your insurance company won’t pay your claim until you pay your deductible. 

The Relationship Between Deductibles and Premiums

We’ve already defined a deductible, but what is an insurance premium? Your premium is the regular payment you must make (either monthly or annually) to maintain your insurance coverage. But how do the two correlate? Your deductible and insurance premiums have an inverse relationship—as one decreases, the other increases. So, an insurance policy with a lower premium will lead to a higher deductible, and a policy with a lower deductible will have higher premiums.

Many policyholders increase their deductibles as a way to save money on their insurance coverage. If this appeals to you, remember that the only catch is that you’re responsible for the deductible in the event of a covered loss, so be sure to choose a deductible amount that you’re comfortable paying. Furthermore, there are instances when paying a higher premium makes sense. For example, if you think you’re at a greater risk of filing a claim due to your location or lifestyle, then choosing a higher premium may make sense for you. The same applies if you prefer minimizing unexpected costs and planning your budget carefully.

We recommend that you carefully explore and assess your premium and deductible options to choose the cost framework that best suits your unique circumstances.

Frequently Asked Questions

Do I have to pay a deductible every time I make a claim?

The simple answer is not necessarily. For instance, if your homeowner’s policy has a $0 deductible, you won’t have to pay for any portion of your property damage or settlement amount. Also, some insurance policies have different deductible amounts for different types of coverage, which means that you may or may not have to pay a deductible when you make a claim.

Usually, health insurance policies have an annual deductible that is cumulative, so you may not necessarily pay a deductible when you make a claim on every medical expense you incur. On the other hand, a car insurance company will not use annual deductibles. Instead, you’re responsible for the car insurance deductible every time you file a claim. After you pay the deductible amount, your insurer covers the remaining repair or replacement cost of your vehicle.

Do deductibles in insurance apply to all types of policies?

Deductibles apply to most insurance policies, from health insurance and car insurance to business insurance and homeowner insurance. However, you may choose to set a deductible as low as $0 for some policies, although this will lead to a higher premium.

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