Deductibles – Concepts and Purpose

A deductible is a specified dollar amount that the insured must pay out-of-pocket before the insurance company will pay for a covered loss. Deductibles are a common feature of many types of insurance policies, including property, auto, and health insurance.

• Definition: A deductible is the portion of a covered loss that the insured is responsible for paying. The insurer pays only the amount of the loss that exceeds the deductible.

I. Concepts of Deductibles:

• A. Fixed Dollar Amount: The deductible is typically a fixed dollar amount, such as $250, $500, or $1,000.
• B. Percentage Deductible: In some cases, the deductible may be expressed as a percentage of the insured value or the loss amount.
• C. Per Occurrence: The deductible typically applies to each separate occurrence or loss.
• D. Policy Limits: The deductible does not reduce the policy limits. The insurer will still pay up to the policy limits for a covered loss, after the deductible has been satisfied.

II. Purpose of Deductibles:

• A. Reduce Premiums:

  • Explanation: By agreeing to pay a portion of the loss, the insured can reduce the amount of premium they pay for the insurance policy.
  • Reasoning: Insurers can offer lower premiums because they expect to pay out less in claims.

• B. Reduce Moral Hazard:

  • Explanation: Deductibles discourage the insured from being careless or intentionally causing a loss.
  • Reasoning: The insured has a financial incentive to avoid losses because they will have to pay the deductible.

• C. Reduce Adverse Selection:

  • Explanation: Deductibles can help reduce adverse selection by discouraging high-risk individuals from purchasing insurance.
  • Reasoning: High-risk individuals are more likely to experience losses and have to pay the deductible, making insurance less attractive to them.

• D. Reduce Administrative Costs:

  • Explanation: Deductibles reduce the number of small claims that the insurer has to process, reducing administrative costs.
  • Reasoning: The insurer only has to process claims that exceed the deductible amount.

• E. Encourage Responsible Risk Management:

  • Explanation: Deductibles encourage insureds to take greater care in preventing losses.
  • Reasoning: By having a financial stake in each loss, insureds are motivated to implement safety measures and manage risks effectively.

III. Types of Deductibles:

• A. Straight Deductible: The insured pays a fixed dollar amount for each loss.
• B. Aggregate Deductible: The insured pays for all losses during the policy period until the aggregate deductible is met. After the aggregate deductible is met, the insurer pays for all remaining covered losses.
• C. Franchise Deductible: If the loss exceeds a specified amount, the deductible is waived, and the insurer pays the entire loss.
• D. Disappearing Deductible: The deductible decreases as the amount of the loss increases.
• E. Waiting Period (in Disability Insurance): Similar to a deductible, the waiting period is the time that must pass after the onset of a disability before benefits are payable.

IV. Factors to Consider When Choosing a Deductible:

• A. Risk Tolerance:

  • Explanation: Individuals with a higher risk tolerance may be willing to accept a higher deductible to save on premiums.
  • Consideration: Those who are more risk-averse may prefer a lower deductible for greater financial protection.

• B. Financial Situation:

  • Explanation: Individuals with a strong financial cushion may be able to afford a higher deductible.
  • Consideration: Those with limited financial resources may prefer a lower deductible to avoid large out-of-pocket expenses.

• C. Premium Savings:

  • Explanation: The amount of premium savings associated with a higher deductible should be weighed against the potential out-of-pocket expenses.
  • Consideration: It's important to determine whether the premium savings are worth the increased risk.

• D. Frequency and Severity of Losses:

  • Explanation: Individuals who are likely to experience frequent but small losses may prefer a lower deductible.
  • Consideration: Those who are likely to experience infrequent but large losses may be willing to accept a higher deductible. Deductibles play an important role in insurance by reducing premiums, controlling costs, and encouraging responsible risk management. When choosing a deductible, it is important to consider your individual circumstances and weigh the potential benefits and drawbacks.