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Deductible

The amount a policyholder is required to pay before an insurance provider will assume an expense

What is a Deductible?

A deductible refers to the amount a policyholder is required to pay before an insurance provider assumes an expense. The deductible is intended to prevent policyholders from making insurance claims that they can reasonably bear the cost for.

 

Deductible

 

The deductible shares the risk between the policyholder and insurer. Ultimately, insurance companies utilize deductibles because they reduce the frequency of payouts, therefore, leading to increased savings.

 

Summary

  • A deductible refers to the amount a policyholder is required to pay before an insurance provider will assume an expense.
  • An entity would purchase insurance to protect against risks that could result in a significant impact on their finances. It is achieved by transferring the cost of a potential loss to an insurance company for an insurance premium.
  • Two major reasons that deductibles are part of an insurance contract are moral hazard and the reduction of overall claims.

 

Practical Example of a Deductible

A homeowner purchases an insurance policy to provide a payout in the case of physical damage inflicted upon the property. If the policy comes with a $2,000 deductible and the home suffers $10,000 in damages, the homeowner would be required to pay out $2,000, whereas the insurance company would need to pay out the difference of $8,000.

 

Why Do Insurers Make Policyholders Pay Deductibles?

There are two major reasons that deductibles are part of an insurance contract:

 

1. Moral hazard

Moral hazard is the behavioral risk that the policyholder will purposefully seek out insurance payouts.

To prevent policyholders from not acting in good faith, insurance companies include a deductible. The deductible provides a financial incentive for the policyholder to act in good faith and not purposefully engage in risky behavior.

 

2. Reduction of claims

The inclusion of deductibles within insurance policies helps protect the insurance company from having to pay out every single insurance policy. Therefore, a deductible shares the risk between the insurer and the policyholder.

Since the inclusion of deductibles decreases risk, insurance companies must ask for lesser insurance premiums because they are taking on less risk.

 

How Does an Insurance Policy Work?

An entity would purchase insurance to protect against risks that could significantly impact their finances. It is achieved by transferring the cost of a potential loss to an insurance company for an insurance premium. The insurance company invests the cash flows to generate a return in order to fund payouts from policy claims.

 

Types of Insurance

  1. Auto insurance: Automobile insurance is for cars, trucks, motorcycles, and other vehicles. It is primarily used to provide financial compensation for the physical damage or bodily injury that results in the case of a traffic accident.
  2. Homeowners insurance: Homeowners insurance is a type of property insurance that protects a private residence from damage.
  3. Disability insurance: Disability insurance refers to a type of insurance that insures the beneficiary’s earned income against the risk that a disability would create a barrier in completing the core responsibilities of their work.
  4. Life insurance: Life insurance refers to a contract between the policyholder and the insurer, where the insurer will pay out a pre-specified amount of money at the policyholder’s time of death, and if the policyholder has paid premiums up until death.
  5. Long-term care insurance: Long-term care insurance provides coverage to the policyholder if they are unable to care for themselves or need assistance in managing daily living activities. Such a type of insurance is not strictly for seniors – if anyone cannot care for themselves for a pre-specified period of time, insurance will cover some of the costs of a care facility.
  6. Health insurance: Health insurance is a type of insurance that covers the risk of a person incurring medical expenses. It is achieved by spreading the risk across several benefactors.
  7. Business insurance: Business insurance is purchased by businesses that wish to hedge against the risk of a contingent or uncertain loss.

 

The Relationship Between Deductibles and Insurance Premiums

The policyholder can generally indicate how much they are willing to pay in terms of an insurance deductible. Generally, if a policyholder opts for a higher deductible, the policy will be less expensive. It is because a higher deductible decreases the risk for the insurance company.

If the policyholder states that they will assume responsibility for part of a claim, the insurance company will provide the policyholder with a minimum deductible. It represents the lowest possible deductible, and therefore, the highest insurance premiums.

 

Related Readings

CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Life and Health Insurers
  • Named Perils Insurance Policy
  • Commercial Insurance Broker
  • National Association of Insurance and Financial Advisors (NAIFA)

Financial Analyst Certification

Become a certified Financial Modeling and Valuation Analyst (FMVA)® by completing CFI’s online financial modeling classes and training program!