The excess is the portion of an insurance claim that you have to pay before the insurer steps in to pay the balance. You and the insurer decide the level of the excess when you first take out the insurance policy. If you choose a higher excess you’ll get lower insurance premiums. The trouble with the excess is that it leaves you exposed to large expenses should you ever need to claim.
There are a few reasons why a higher excess results in lower premiums. The most obvious reason is, that the lower amount the insurer has to pay out allows them to charge you lower premiums. In addition to this, the excess ensures that you do not submit claims lower than the excess amount. This saves the insurer on the amount of the claim and the costs they would have faced in processing the claim.
Insurers also use the excess to encourage you to avoid any situation that could result in a claim. A common example in insurance circles is that of people with home contents insurance. Consider a situation where you left your home but couldn’t remember whether you switched your stove off or not. Your behaviour could be very different depending on whether you have insurance or not. Not having insurance makes you more likely to go back and check. A person with insurance may be willing to take the risk knowing that if any damage occurred, insurance would pay. This behaviour is known as moral hazard. The excess is intended to reduce the effects of moral hazard since making an insurance claim would mean that you also need to fork out some cash.
An excess can be a useful way of reducing the cost of your insurance premium. Having said that, you still need to be careful not to set it so high that you run into trouble should you ever need to claim.