It is not uncommon for insureds, even sophisticated ones, to be confused about the precise meaning of the coinsurance clause found in their property insurance policies. In fact, many insureds fail to appreciate the effects of the coinsurance clause until they are endured after a loss. While experience may be the best teacher, it is rarely the cheapest, particularly when the lesson involves the coinsurance clause a/k/a the coinsurance penalty.
Simply stated, a coinsurance clause provides that the insurance company and the insured will each pay a percentage of a claim if the insured fails to insure the property for the limits required by the insurer within their coinsurance clause.
So, let’s consider a hypothetical situation involving two identical warehouses worth $100,000 at the time of the loss. Bill purchases a property insurance policy with coverage equal to the full value of the property ($100,000). Ted purchases an identical policy, but with a limit equal to half the value. A severe thunderstorm causes identical $30,000 losses to both properties. Will the insurance company pay Bill and Ted the same amount for their claims, even though Ted paid significantly less in premiums and insured only half of the value of the property? The answer is ‘no.’
A typical coinsurance clause will establish the minimum amount of insurance that is required to avoid a reduction in the amount the insurer will pay for a loss. This amount is generally expressed as a fixed percentage of the value of the property at the time of the loss, frequently between 80% and 100%. If the property is not insured for at least the required amount, then the insurance company may shift part of the responsibility for the loss to the insured.
A coinsurance clause will also explain how to determine whether a coinsurance penalty will apply, and, if so, how much it will be. This formula considers the amount of insurance actually carried by the insured and divides this amount by the amount of insurance that should have been carried. The resulting percentage is multiplied by the value of the loss.
To better understand the calculation, it is helpful to demonstrate the process by returning to the Bill and Ted hypothetical, only now, an 80% coinsurance requirement has been added.
Ted (Underinsured): Property Value at time of the Loss = $100,000; Limit of Insurance = $50,000; Coinsurance = 80%; Loss = $30,000; Deductible = $500.
- Actual Property Value x Coinsurance % $100,000 x .80 = $80,000 2. Policy Limit / # from Step 1 $50,000 / $80,000 = .625 3. Loss x # from Step 2 $30,000 x .625 = $18,750 4. # from Step 3 minus deductible $18,750 – $500 = $18,250
In Ted’s case, the insurance company would pay the lesser of the amount determined in Step 4 ($18,250) or the limit of insurance ($50,000). So, the insurance company will pay Ted $18,250 and Ted will have to absorb a coinsurance “penalty” for the remaining amount ($11,750).
Bill (Insured to Value): Property Value at time of the Loss = $100,000; Limit of Insurance = $100,000; Coinsurance = 80%; Loss = $30,000; Deductible = $500.
- Actual Property Value x Coinsurance % $100,000 x .80 = $80,000 2. Policy Limit / # from Step 1 $100,000 / $80,000 = 1.25 STOP! A coinsurance penalty does not apply when the result of step 2 is 1.00 or higher.
Since Bill is not subject to the coinsurance penalty, the insurance company would pay the full amount of the loss (up to the limit of insurance), minus the deductible. So, the insurance company will pay Bill $29,500 for his $30,000 loss.
These illustrations highlight two items worth noting. First, the actual impact of the coinsurance penalty, in terms of dollars paid on a partial claim, can be huge. If a policy’s coinsurance provision is ignored, the results can be devastating to a cash-strapped organization dealing with a partial loss, regardless of whether the coinsurance clause was ignored deliberately or negligently.
Second, Bill’s example highlights the middle ground between insuring to 100% of value and insuring to the minimum percentage required by a coinsurance clause, which is 80% in Bill’s case. Although Bill could have saved on premiums by only insuring the property for the required 80%, he would have been underinsured in the event of a total loss. Bill’s approach is the most risk averse, and the most expensive. Those insureds capable of withstanding a greater risk in the event of a total loss may find some wiggle room when determining the amount of insurance to purchase. Given the increased risk, it is best to go over this option only with an experienced insurance agent.
It is important to remember that the value of the property is established at the time of the loss. If property values increase, insureds must make sure their coverage limits are increased as necessary to maintain the appropriate level of insurance required by the coinsurance clause. Alternatively, there are options that do not require an insured to constantly increase limits to keep pace with increases in property values, such as negotiating an agreed value provision in a policy.
Although navigating the complexities of coinsurance is best done with the assistance of an experienced insurance agent, insureds can benefit from having a basic understanding of their own. For example, understanding coinsurance permits an insured to better judge the competency of a current or prospective insurance agent. An agent who is unable to correctly explain the concept, theoretically and practically, should be dismissed as an option because the consequences of getting coinsurance wrong are simply too great.
Second, understanding coinsurance can protect an insured from being taken advantage of by unscrupulous agents. Since coinsurance can significantly affect actual amounts paid by an insurance company in the event of a partial loss, changing limits and coinsurance percentages can dramatically affect the premium. By tweaking these figures, an agent can submit a proposal for insurance with significantly reduced premiums in order to win the business. Those who understand the concept of coinsurance can avoid falling for this tactic by identifying how the reduction in premium was achieved, and understanding that the true cost of the savings is the assumption of a potentially devastating risk.
Coinsurance involves far too many details, variations, and nuances to be fully discussed in a single article. As is often the case with insurance, just because an option is good for one does not necessarily mean that it will be good for another. An experienced insurance agent will not only help an insured avoid the potentially devastating pitfalls of coinsurance, but will also understand how to use coinsurance as a tool to obtain coverage that is economical and consistent with an insured’s specific risk tolerance.
If you would like more information about coinsurance, or if you would like us to take a look at your insurance coverage’s, please contact us.