Coinsurance 101

You’d think after 100+ years of application that coinsurance questions would rarely arise. However, few commercial property provisions are debated more often than coinsurance. In this article, we’ll take a look at several coinsurance issues – a couple of them basic, but fundamentally important, and another one a little more complicated – and we’ll also link to another article that you can use to explain coinsurance to your clients.

Question 1

“I am looking for the reason why the insurance industry has included the coinsurance clause in their property policies. If someone has a building worth $500,000 and they know it is worth $500,000 but only want to insure it for $300,000, why does the insurance company apply a penalty at the time of a loss? (This is assuming that the consumer knows they are insuring for less than the value of the property and that they will only get paid up to the policy limit. Does it have to do with how replacement cost works? Or is it because the insurance companies have another specific reason why they will only “insure to value”? Also, why isn’t coinsurance defined in the definitions section? I would be interested in the history of how this came about too.”

Response 1

We have an article in our research library that explains much of this: How to Explain Coinsurance to Clients.

While the coinsurance clause is effectively a “penalty” for underinsuring, another way to look at it is that it’s also an incentive to insure to value. The higher the ratio of insurance to value, the lower the rate and the cost per $100 of insurance. The article cited above gives a couple of examples. In addition, while the policy doesn’t “define” coinsurance, examples of how it works are included in the policy. The history of coinsurance is mentioned in the article above.

It is possible to write insurance on a building without coinsurance, though it is usually very expensive to do so and very few insurers offer this option. Since most losses are partial, there is a relatively greater incidence of proportionately higher losses, the lower the limit. The article also discusses this.

You can also insure on an agreed value basis which suspends the coinsurance clause. This is normally done on a full insurance to value basis, but there are some insurers who will permit its use on lower limits…again, expect to pay relatively more for the insurance (i.e., higher rate).

Finally, if the MARKET value of the building is less than actual cash value (ACV) or replacement cost, you can insure on a functional replacement cost basis. You may own an older building with 12-inch brick walls, heavy timber construction, etc. The replacement cost with materials of like kind and quality might be $1,000,000, but the market value is only $400,000. With the functional replacement cost endorsement, you can insure for the latter amount.

If you’re insuring an eligible building/business under a BusinessOwners type program, there is usually not a coinsurance clause per se. Many of these policies are written similar to a homeowners policy. If you insure to at least 80% of the building value, you will recover on a replacement cost basis…if you insure for less than that amount, you recover actual cash value. Since this type of policy varies from company to company, their valuation clauses may also vary.

So, there are ways around the coinsurance provision, though the relative cost is higher than insuring to value. And, of course, if the building is mortgaged, the mortgagee will insists on adequate insurance to value to protect their interest. As a practical matter, most property owners will want to fully insure their assets…as Martha Stewart says, “It’s a good thing.”

Question 2

“I have a question on coinsurance. Here is the example. Building insured for $450,000. Estimated replacement cost is $650,000. 90% coinsurance. Probable total loss. Would the carrier use the coinsurance clause in a total loss scenario? I know it will apply towards a partial loss. Would they consider paying the policy limit since it is a total loss?”

Response 2

Whenever there’s a total loss, mathematically, it doesn’t matter whether there’s a coinsurance penalty since the policy will always pay the policy limit. Here’s the coinsurance calculation (forgetting the deductible) for your example:

Policy Limit
Recovery = —————- X Loss Amount
Coins. % X Value

$450,000
Recovery = ————– X $650,000 = $500,000
90% X $650,000

Therefore, the loss payment is limited to the policy limit of $450,000. The reason it’s mathematically impossible for the coinsurance calculation to end up higher than the policy limit is the formula above. The “Value” and the “Loss Amount” in a total loss are the same. So, by canceling those amounts out in the numerator and denominator of the calculation (e.g., $650,000 divided by $650,000), you reduce the formula to:

Policy Limit
Recovery = ————
Coins. %

In direct property insurance, the Coinsurance % is usually 80%, 90% or 100%. So, the coinsurance recovery according to the calculation will always be greater than or equal to the policy limit since that limit is being divided by a number less that’s one or less (1.0, 0.9, or 0.8)…the loss recovery is then limited to the lesser policy amount.

Question 3

“My client rents a spot in a strip mall. Someone kicked in the door, smashed some glass and took his stuff. The landlord told him that his lease requires him to replace the glass doors (I found out he’s also responsible for damage to the A/C unit.) I turned the claim into his CGL carrier and was told this was excluded due to CCC and contractual liability. I now know he needs building coverage. In fact he had the CP 00 10on the place, but with “contents” coverage only. Let’s suppose the doors, glass, and A/C unit total $20,000 in value. Does the guy just buy $20K of building coverage? Is there no coinsurance problem since the value of the building is hundreds of thousands or millions of dollars? I now understand the need for building coverage, but I’m having a hard time getting past the coinsurance deal.”

Response 4

Well, looks like you’ll learn at least four valuable lessons from this claim. First, when an insured leases space, inquire about his contractual insurance requirements. We have an article that addresses issues commonly found in leases called Complying with Triple Net Lease Insurance Requirements.

Second, you’ve learned that the CGL policy has exclusions. For property owners and tenants, an important one is that there is essentially no coverage for property you own, rent, or that’s in your care, custody or control. Third, you now have a greater appreciation of E&O insurance. And, fourth, to know how coinsurance works in a scenario like this, you have to read the policy carefully…the answer lies in the insuring agreement and the coinsurance condition. The CP 00 10defines covered property as:

1. Covered Property
Covered Property, as used in this Coverage Part, means the type of property described in this section, A.1., and limited in A.2., Property Not Covered, if a Limit of Insurance is shown in the Declarations for that type of property.
a. Building, meaning the building or structure described in the Declarations.

It covers “described property,” so you just explicitly define the property as the glass, A/C unit, etc. The coinsurance clause says:

We will not pay the full amount of any loss if the value of Covered Property at the time of loss times the Coinsurance percentage shown for it in the Declarations is greater than the Limit of Insurance for the property.

Again, covered property is that defined on the Dec page. Since you are describing just selected property as “Covered Property,” only the value of that property is used in the coinsurance calculation. Just be careful that you explicitly describe the property…coverage gaps too often arise when property or premises is not properly described on the Dec page.