What are insurance deductibles, and why does your insurance have them?

An essential part of an insurance contract, a deductible is the amount the policyholder agrees to pay out of pocket before the insurer shoulders the cost of coverage.

One important thing to note, however, is that although it is common in the industry to hear “after paying for a deductible,” most of the time, policyholders do not actually pay anything to their insurance providers. Rather, they pay for something equal to the deductible amount – car repairs or medical tests, for example – then the insurer pays out for the rest of the coverage up to the maximum limit. 

In some instances, insurance companies subtract or deduct – hence the term deductible – the amount from the insured loss before paying out up to the limits of the policy.      

You can check out the meaning of common insurance industry terms in our jargon buster. 

The Insurance Information Institute (Triple-I) describes a deductible as “how risk is shared between the policyholder and the insurer.” This is also the reason why insurance policies have deductibles.

Because they share the cost of the claims with the policyholders, insurance providers can avoid receiving a barrage of small and inexpensive claims, so they can focus on major losses, which insurance policies are designed for.

In a way, having deductibles can also make policyholders think twice about engaging in risky behaviors or not acting in good faith as they will be financially impacted by any loss or damage as well. This effectively aligns the interest of the insured with that of the insurer, which is to mitigate the risk of major losses.

There are two ways how insurers impose deductibles in an insurance policy:

1. Standard deductible: Indicates a specific dollar amount to be paid out in an event of a claim.
2. Percentage deductible: Defines a specific percentage of the policy limit to be paid out in an event of a claim.

The deductible amount is indicated in the terms of coverage on the declarations page, or the first page, of an insurance contract.  

According to Triple-I, state insurance regulations strictly dictate the way deductibles are incorporated into the policy’s language and how these are implemented, although laws can vary between states. 

Almost all insurance policies come with a deductible, except for life insurance, where the beneficiaries receive a tax-free lump-sum payment after the policyholder dies.  

A single policy may also have multiple deductibles as each coverage may have its own deductible amount. The only exception is health insurance, where plan holders usually need to meet a single deductible for an entire calendar year.  

Here’s how insurance deductibles work for the different types of insurance policies.

In home insurance, deductibles apply only to property damage. Homeowners do not need to pay a deductible for liability claims. The deductible also applies each time a claim is filed.

For policies with standard or dollar-amount deductible, the deductions work pretty straightforward – the amount specified in the contract will be subtracted from the claims payout. If a policy has a $500 deductible, for instance, then the insurer will pay the policyholder $9,500 for an insured loss worth $10,000.

For plans with a percentage-based deductible, the amount the insurance company covers is calculated based on a percentage of the property’s insured value indicated in the policy document. For homes insured for $250,000 with a 2% deductible, for example, the insurer will send the homeowner a claims check for $24,500. Percentage deductibles generally apply only to home insurance policies, and not to other types of plans.

Disaster deductible: How does it work?

While standard homeowners’ insurance policies cover wind, hail, storm, and hurricane damage, protection against certain types of calamities – including flooding and earthquake – must be purchased separately. 

Many home insurance plans come with special deductibles – also referred to as disaster deductibles – that apply to claims attributable to different natural calamities.  Here’s how they work: 

• Hurricane deductibles: Typically following a percentage-based model, hurricane deductibles are often higher than other types of home insurance deductibles. Some US states give homeowners the option to take out a standard deductible in exchange for more expensive premiums, as long as the house is not located in a hurricane-prone area.
• Wind and hail deductibles: Working similar to hurricane deductibles, wind and hail deductibles are commonly based on a percentage of the home’s insured value, usually ranging between 1% and 5%.
• Flood insurance deductibles: Available in standard or percentages, the deductible amount varies depending on where the home is located and the insurance provider. Policyholders can also choose different deductibles for the house and personal belongings.
• Earthquake insurance deductibles: These follow a percentage-based model, ranging from 2% to 20% of the home’s replacement value. Insurers in earthquake-prone regions often set the minimum deductible amount at 10%.

These deductibles work almost the same way as those for home insurance, except that percentage-based deductibles do not apply. Policyholders also pay deductibles only for vehicle damage and not for liability claims. 

Generally, car insurers allow motorists to choose separate deductibles for collision and comprehensive coverage, even if they have the same amount. 

Disappearing deductible: How does it work?

A disappearing deductible – also referred to as a diminishing or vanishing deductible – is an additional coverage in an auto insurance policy that decreases the deductible amount each year that the policyholder maintains a clean driving record. It is also a way for car insurance companies to reward safe drivers. 

For each accident- and claims-free year, a motorist can earn certain disappearing deductible credits, which can accumulate and be used to reduce the deductible amount of their collision and comprehensive policies. It is also possible for drivers to reach $0 deductibles if they maintain a clean driving record long enough. 

The credits typically reset once the policyholder makes a claim or is involved in a car accident. 

Unlike in home and auto insurance policies where each coverage may have its own deductible amount, health insurance plan holders are required to meet a single deductible for an entire year. After they max out on their deductibles, they will then split the costs with their insurer in a system called coinsurance until they reach their out-of-pocket maximum. 

Coinsurance follows a percentage-based model. For example, in a 20%-80% split, the plan holder pays 20% of the healthcare costs while the insurer covers the remaining 80% until the out-of-pocket limit is reached. Once they hit this limit, the insurance company then pays 100% of their healthcare expenses for the rest of the year.

Depending on the health insurance plan, policyholders may have an individual or family deductible, or a combination of the two. An individual deductible applies to plans with single coverage and works the same way described above.

Family deductibles, meanwhile, come in two types:

1. Aggregate deductible: One total deductible for the whole family.
2. Embedded deductible: Apart from a family deductible, there are also individual deductibles for each family member.  

Premiums and deductibles are two of the major out-of-pocket costs associated with insurance, which is why they may sometimes be confused with one another. While an insurance premium is the amount a policyholder pays in exchange for coverage, a deductible is the amount the insured needs to pay for damages before coverage kicks in.

These two, however, have an inverse relationship. As one increases, the other decreases, so generally the higher the deductible, the lower the insurance premium, and vice versa.

Is it better to have a higher or lower insurance deductible

When it comes to insurance policies, is it better to have a higher or lower deductible?

According to some experts, choosing a lower deductible makes sense if the policyholder expects to access coverage more often or if they will not be able to afford large out-of-pocket expenses. These may be because they are exposed to higher levels of risks or have not saved enough for an emergency fund.

Meanwhile, a higher deductible can be a good option for policyholders who do not expect to make a lot of claims. This strategy also enables them to reduce insurance costs and allocate the extra money to their savings. 

What about you? Do you prefer a higher or lower insurance deductible? How much deductible amount do you think is right for each insurance plan? Share your thoughts in the comments section below.