If you’re in the market for insurance, you may wonder what a deductible is in health, auto, or homeowners’ insurance policies—and how it works.

Insurance deductibles are common to property, casualty, and health insurance products. They’re out-of-pocket costs that you must pay before your insurance coverage kicks in.

Typically, the higher your policy’s deductible, the lower the annual or monthly premium payments. That’s because you’re responsible for more costs before coverage starts.

Here’s a quick look at why insurance policies have deductibles, what a deductible in health insurance is, and how health insurance deductibles work.

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

Deductibles help mitigate the behavioral risk of moral hazards. A moral hazard is 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.

Insurance policies also use deductibles to ensure a measure of financial stability on the part of the insurer. A properly structured insurance policy protects against catastrophic loss. A deductible provides a cushion between any given minimal loss and a truly catastrophic loss.

For example, 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.

With a health insurance policy, deductibles are only part of the expenses you face. In addition to your monthly premium, you pay part of the costs through:

• Your deductible. This is the amount that you must spend each year on covered healthcare expenses before your insurance starts to pay some of the costs. In general, the lower the health insurance deductible, the more expensive the policy.
• 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 healthcare expenses.

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.

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. Here’s an example.

Suppose 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.

Insurance policies have deductibles to ensure policyholders have “skin in the game” and that all parties—the company and its policyholders—share in 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.