Why Do Insurance Policies Have Deductibles?

What Are Deductibles?

Are you in the market for health, auto, or homeowners insurance? If so, you may be wondering what deductibles are and how they work. Insurance deductibles are common to property, casualty, and health insurance products. Put simply, they're out-of-pocket costs that you must pay before your insurance coverage kicks in and pays out your claims.

Deductible values vary based on the coverage, insurer, and how much you pay in premiums. The general rule is that if your policy comes with a high deductible, you'll pay lower premiums every month or year because you're responsible for more costs before coverage starts. On the other hand, higher premiums usually mean lower deductibles. In these cases, the insurance plan kicks in much quicker.

Here's a quick look at why insurance policies have deductibles, an overview of health insurance deductibles, and how health insurance deductibles work.

Why Insurance Policies Have Deductibles

Deductibles help insurance companies share costs with policyholders when they make claims. But there are two other reasons why companies use deductibles, including moral hazards and financial stability.

Moral Hazards

Deductibles help mitigate the behavioral risk of moral hazards. A moral hazard lies in the risk that a policyholder may not act in good faith. Insurance policies protect policyholders from losses, so an inherent moral hazard exists: The insured party may engage in risky behavior without having to suffer the financial consequences.

For example, if drivers have car insurance, they may have the incentive to drive in a reckless manner or leave their vehicle unattended in a dangerous area because they're insured against damage and theft. With no deductible, they have no skin in the game.

A deductible mitigates that risk because the policyholder is responsible for a portion of the costs. 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 use deductibles to ensure a measure of financial stability on the part of the insurer by reducing the severity of claims. A policy that is properly structured provides protection against catastrophic loss. A deductible provides a cushion between any given minimal loss and a truly catastrophic loss.

Suppose an insurance policy didn't have a deductible. The cost of every minor claim, regardless of the amount, would be the insurer's responsibility. This would create an overwhelming number of claims and increase the financial costs of the policy. It could also make it difficult for the insurer to respond properly to actual catastrophic losses from policyholders.

Health Insurance Deductibles: Only Part of Your Costs

Deductibles are only part of the expenses you face with health insurance policies in addition to your monthly premiums. Remember that your deductible is the amount you must spend each year on covered healthcare expenses before your insurance starts to pay some of the costs. There are policies available that have no first dollar—deductibles—however, they usually carry expensive premiums and cap their coverage.

In general, the lower the health insurance deductible, the more expensive the policy, and vice versa.

You're also required to cover the following:

• Copayments or copays. These are set amounts that you pay for specific covered healthcare expenses. For example, you might have a $10 primary care copay and a $40 copay for specialists. You don't need to meet your deductible first.
• Coinsurance. Once you meet your deductible, you'll be responsible for part of your healthcare costs, and your plan will pay the rest. This is called coinsurance. You continue to pay coinsurance until you meet your out-of-pocket maximum for the year.

An out-of-pocket maximum is the most you'll pay for covered healthcare expenses in one year. Once you reach that out-of-pocket maximum, your plan pays 100% of covered expenses.

How Do Health Insurance Deductibles Work?

Deductibles work differently for various types of insurance policies. If you have a $500 deductible with your auto insurance, it's easy to figure out what you'll pay if something happens that's covered by the policy: $500. After that, your insurance company picks up the tab. But it's not so easy with health insurance. With these policies, your deductible is the amount you pay out-of-pocket before your insurance starts sharing costs with you through coinsurance.

Let's say you have a $2,000 deductible, a $50 copay, 80/20 coinsurance, and an out-of-pocket maximum of $3,000. You visit an orthopedist ($50 copay) because you have hip pain. The doctor orders an MRI to find out what's causing the pain. The MRI costs $2,000. You pay the full amount, and in doing so, you meet your deductible.

The MRI shows you have a torn labrum in your hip, and that you'll need surgery to fix it. All in, the surgery costs $20,000. Your 20% coinsurance comes out to $4,000. But since you have a $3,000 out-of-pocket maximum, you only owe $1,000. Your insurance pays the rest, provided all the charges are covered expenses. 

Some plans come with higher deductibles. These are called high-deductible health plans (HDHPs). They come with minimum deductibles of $1,400 for individuals and $2,800 for family plans in 2022 and generally require lower monthly premiums. For 2023, the minimum deductibles are $1,500 for individuals and $3,000 for family plans.

Out-of-pocket maximums typically don't go over $7,050 for individuals and $14,100 for family coverage in 2022. For 2023, these numbers are $7,500 and $15,000, respectively. These plans are well-suited for people who don't expect to pay too much for coverage.

The Bottom Line

Insurance policies have deductibles to ensure policyholders have skin in the game and that all parties involved—the insurance company and its policyholders—share some of the costs. In general, a policy with a low deductible, whether it's for auto, home, or health, will cost more than a policy with a high deductible, all other factors being the same. Remember that with any insurance, it pays to shop around to make sure you find a policy that matches your needs and your budget.