Insurance Deductibles

A deductible is the amount of money subtracted from the value of a loss, which is not covered by insurance. For instance, if you are in an auto accident, and you suffer collision damage of $10,000 and have a deductible for collision of $500, then your insurance company will pay you $9,500 for your loss. If the collision damage is $450, then you collect nothing, because it is lower than your deductible.

The reasons for deductibles are to eliminate small claims, which helps keep premiums affordable, and to reduce moral and morale hazard. Coinsurance is another method commonly used to keep premiums affordable by having the insured pay part of the cost.

Since processing claims requires a minimum cost that is mostly independent of the amount of the claim, the expense of processing a small claim would constitute a large percentage of the claim itself. Thus, deductibles are an effective way to keep premiums affordable. Furthermore, most people or businesses can easily afford to pay for small losses with earned income. The primary purpose of insurance is to cover large, catastrophic losses—what is sometimes called the large-loss principle—that could financially ruin an individual or business.

Deductibles also reduce premiums by lowering the payouts for the losses by the insurance company. However, the size of the deductible and the amount of the savings is not linear. By increasing the size of the deductible, savings will be much greater at first, but decline dramatically with larger deductibles. For instance, the standard deductible for collision in car insurance is $500. If this insurance costs you $1,000 per year, increasing the deductible to $1,000 may reduce the premium to $800 per year. So in this scenario, by taking the lower deductible of $500, you are paying $200 per year for $500 worth of coverage—not a very good cost-benefit ratio. If you increase the deductible to $2,000, then your premium may only drop another $20. Thus, when buying insurance, it pays to compare various deductibles and the associated premiums.

Deductibles also help to reduce moral hazard, where the insured causes losses to collect the insurance money, because the insured will suffer the loss of the deductible for any losses. Losing the deductible also helps to reduce morale hazard, which exists because the insured may otherwise be nonchalant about losses, and do little to prevent losses because of insurance.

Some types of insurance do not have deductibles. For instance, life insurance policies do not have a deductible because a deductible has no benefit. A deductible in life insurance would not be a moral or morale hazard, and there are no small claims—death occurs or it doesn’t. Liability insurance also has no deductible, because almost all liability claims will be for fairly substantial sums of money, and because the insurer will want to handle the case from the beginning to minimize legal mistakes that could be more costly later on.

Deductibles in Property Insurance

Property insurance has 2 types of deductibles: lump sum and the percentage of the insured property. A lump-sum deductible is equal to a specific amount, such as the $500 deductible that is common for car insurance. A percentage deductible is equal to a specified percentage of the value of the insured property.

The deductible is applied either as a straight deductible or an aggregate deductible.

A straight deductible is a deductible that applies to each separate loss, and is the type of deductible in most personal lines of insurance. For instance, if, during the course of a year, you are involved in 2 separate auto accidents, then the deductible will be subtracted for each accident.

Commercial insurance often has an aggregate deductible, which is the total deductible for a given policy period. For instance, if a business has property insurance with an aggregate deductible of $10,000, then the business will have to cover the 1st $10,000 worth of losses for each policy period—usually a year. So if, during the course of a year, a business has 3 separate losses of $2,000, then $6,000, then $4,000, the business will have to cover $10,000 of its losses, but will receive $2,000 from its insurance company for the last loss. Any more losses that occur within the same policy period will be fully covered. So if the business has another loss of $3,000, it will receive the full amount from its insurer.

An aggregate deductible makes more sense in commercial insurance, since businesses can have many separate losses during the course of a year, but would be unusual for an individual to experience multiple losses within a year.

Deductibles in Health Insurance

Deductibles for health insurance can be in the form of dollars or time. Most medical insurance policies have a dollar deductible, while disability insurance has a time deductible, where the insured must wait a specific amount of time after a disability to collect any insurance.

The most common type of deductible for basic medical expenses and major medical contracts is the calendar-year deductible, which is the amount that must be paid by the insured in a calendar year before the insurance company pays anything. After the insured has paid the deductible for the year, then the insurance company pays everything for the rest of the year. This is basically the same as the aggregate deductible in commercial insurance policies.

Often, employers provide employees with a basic medical expense plan that is supplemented with a major medical plan. A corridor deductible is the deductible that applies to the major medical plan that only pays what the basic plan does not, plus a specific dollar amount; thus, it bridges the 2 policies (hence, the name).

Most disability insurance policies have an elimination period deductible (aka waiting period) of 1 or more months, which requires the insured to be disabled for a time greater than the waiting period, and for which payments will be paid only for the time after the waiting period when the insured is disabled. To collect social security disability benefits, for instance, requires a waiting period of 1 year. Like the dollar deductible, shorter waiting periods command higher premiums.

Elimination period deductibles are common for any type of insurance that pays a specified amount over a period of time, because it is more effective as a deductible than the dollar amount deductible. Like dollar deductibles, elimination period deductibles reduce premiums by eliminating small claims of disability of short duration, which should be paid by the insured with savings or other liquid assets. Also, dollar amount deductibles make no sense when the insurance provides a regular stream of payments, because the amount of the regular payments is specified in the contract, in contrast to other types of insurance that covers only losses and their associated expenses, where the amount of payment is determined by the amount of the loss.

New Developments

Percentage Deductibles Becoming Norm for Damages from Natural Disasters

Higher Deductibles Sting Homeowners

Many insurance companies are now using percentage deductibles in 17 states vulnerable to such natural disasters as wind, flood, hail, and earthquake—that range from 1% - 15% of the insured value of the home—instead of the traditional dollar deductible, such as a $1,000 deductible, for instance. Percentage deductibles usually result in higher deductibles that help insurance companies limit their losses in a major disaster. For instance, a house insured for $500,000 with a 5% deductible is equal to a $25,000 deductible. Although the deductible is higher, insurance premiums are generally lower with percentage deductibles. However, some states, such as North Carolina and Georgia, don't allow percentage deductibles. Some states give consumers a buy-back option that allows them to have a dollar deductible in exchange for higher premiums.