Why Do Insurance Policies Include Deductibles and Co-Insurance?

Insurance provides protection against unforeseen events that could lead to financial hardship. Its purpose is to transfer financial risk from an individual or entity to an insurance company. Policies are structured with components that define how this risk is shared between the insurer and the policyholder.

Understanding Deductibles

A deductible is a fixed amount a policyholder must pay out-of-pocket before insurance coverage begins to pay for covered losses. This amount is subtracted from the total claim payment the insurer would otherwise make. For example, if a policy has a $1,000 deductible and a covered event results in a $5,000 loss, the policyholder pays the initial $1,000, and the insurer covers the remaining $4,000.

Deductibles encourage policyholders to share in the cost of a claim. This incentivizes individuals to be more careful with insured assets, as they bear some financial responsibility. Deductibles also reduce the number of small claims filed, which are administratively costly for insurers to process. This mechanism helps mitigate “moral hazard,” where individuals might be less cautious if all costs are fully covered by insurance.

Understanding Co-insurance

Co-insurance is the percentage of costs a policyholder pays for covered services after their deductible has been met. Unlike a deductible, which is a fixed dollar amount, co-insurance is a proportion of the remaining expenses. For instance, with an 80/20 co-insurance plan, after the deductible is met, the insurance company pays 80% of eligible costs, and the policyholder pays the remaining 20%. This arrangement is common in health insurance but can apply to other policy types.

Co-insurance further shares financial responsibility for larger claims, particularly in healthcare. It serves as a cost-containment measure by ensuring policyholders maintain a financial stake in higher-cost services. This percentage-based sharing discourages unnecessary or excessive use of services that might be over-utilized if fully covered. Similar to deductibles, co-insurance also helps mitigate moral hazard by requiring policyholders to contribute a portion of the expense.

How Deductibles and Co-insurance Affect Premiums

The presence and level of deductibles and co-insurance directly influence insurance premiums. A fundamental principle is the inverse relationship between these cost-sharing mechanisms and the premium amount. When policyholders assume more financial risk through higher deductibles or co-insurance percentages, insurers face less exposure to potential payouts. This reduced exposure allows insurance companies to offer lower monthly or annual premiums.

These mechanisms provide policyholders with control over their premium costs. Choosing a higher deductible or greater co-insurance percentage can result in a lower ongoing premium, appealing to those who prefer lower upfront costs. Conversely, a policy with a lower deductible or co-insurance will typically come with a higher premium, as the insurer takes on more immediate financial burden.

For insurers, deductibles and co-insurance are tools for managing financial risk and maintaining solvency. They help predict payout liabilities more accurately and contribute to the overall stability of the insurance system. This balance between premium affordability for policyholders and risk management for insurers helps ensure insurance remains accessible and sustainable for a broad population.