Insurance Policy Deductibles

Insurance deductibles are common to property, casualty, and health insurance products. These are out-of-pocket costs that are required to be paid before the insurance coverage will kick in. Deductibles may be per-occurrence or accumulate as an annual amount. Consider a health insurance claim where an insured person recently spent $2,000 in covered medical expenses and has a $300 annual deductible.The policyholder will pay $300 out-of-pocket, and the insurer will pay the remaining $1,700. Once meeting the annual deductible amount, the insurer covers the full costs for the rest of the year. Additional costs, such as co-payments and co-insurance, may also apply.

Typically the higher a policy's deductible, the lower the annual or monthly premium payments, since the insured will be responsible for more cost before coverage starts. But why are these payments necessary? Insurance policies have deductibles for both behavioral and economic reasons.

Key Takeaways

  • Insurance deductibles are out-of-pocket payments paid up to some limit before insurance coverage begins paying.
  • Without a deductible, moral hazard would be a more costly problem, that is people would frivolously buy insurance and especially those who know that they will need the coverage to be paid.
  • Deductibles also cushion against financial stress caused by catastrophic loss or an accumulation of small losses all at once for an insurer.

Moral Hazards

Deductibles mitigate the behavioral risk of moral hazards. A moral hazard describes the risk that two parties to an agreement or contract may not act in good faith. Because insurance policies protect the policyholder from loss, a moral hazard exists; the insured party may engage in risky behavior due to the protection provided by the insurance policy he holds.

For example, if a driver holds an automobile insurance policy, he may have the incentive to drive in a reckless manner or leave his vehicle unattended in dangerous areas because he is insured against damage or theft. A deductible mitigates the risk that the insured party may engage in reckless behavior. The insured party is responsible for a substantial portion of the costs in the event of catastrophic loss along with the insurer. In effect, deductibles serve to align the interests of the insurer and the insured so that both parties seek to mitigate the risk of catastrophic loss.

Financial Stability

Insurance policies also use deductibles to ensure a measure of financial stability on the part of the insurer. A properly structured insurance policy should protect against catastrophic loss. A deductible provides a cushion between any given minimal loss and a true catastrophic loss that allows the insurance company to administer its policies.

For example, suppose an insurance policy did not have a deductible in place. The cost of every minor claim, regardless of the severity of loss, would be the responsibility of the insurer. Any small dent in an automobile or minor property damage on a home would create a claim the insurer must address. This scenario would create an overwhelming number of claims and increase the financial costs of the policy, damaging the ability of the insurer to respond properly to actual catastrophic losses from policyholders.