What is the function of a 'deductible' in an insurance policy?

A deductible in an insurance policy serves as a specified amount that the insured must pay out of pocket before the insurance company starts to cover any losses related to a claim. This amount is intended to encourage policyholders to take personal responsibility for minor claims and mitigate moral hazard, which can arise when individuals are insulated from risk due to insurance coverage.

When a loss occurs, the insured is required to pay the deductible amount directly, and only after that is the insurer responsible for covering the remaining balance of the claim, according to the terms of the policy. For example, if the deductible is set at $1,000 and a covered loss amounts to $5,000, the policyholder will pay the first $1,000, and the insurer will cover the remaining $4,000.

This mechanism also helps balance the cost of insurance premiums, as higher deductibles generally lead to lower premiums. Understanding the role of deductibles is crucial for policyholders, as it affects both their financial liability in the event of a claim and the cost they pay for insurance coverage.