COINSURANCE: WHY AND HOW?

Rough Notes, Apr 2004 by Prahl, Robert J

Help your clients understand the concept and buy the coverage they need

Have you ever been asked to explain the purpose of coinsurance or to give an example of how it is applied? If so, you may have developed a good explanation of the concept with a practical example that demonstrates its application. However, if you haven't developed such a response or haven't yet been asked to explain it, you may benefit from the following definition:

Coinsurance can be described as a property insurance provision that imposes a penalty on an insured's loss recovery if the limit of insurance purchased is not at least equal to a specified percentage of the value of the insured property.

Why is a coinsurance provision necessary?

It is well established that most building property losses are partial in that they do not result in the total destruction of the structures involved. For insureds who recognize this, there may be a tendency to play the odds and limit the amount of insurance purchased. Why pay the premium for full coverage when chances are the full amount may never be needed? Of course, when the property is pledged as security for a mortgage loan, the mortgage company usually requires that the property be insured for an amount that will cover the balance of the mortgage. Even then, however, there may be some latitude in estimating the value of the property in question.

Since it is true that most losses are partial, individuals who purchase full coverage ordinarily would pay an inordinately higher premium than those who play the odds and limit the amount of their insurance. Therefore, insureds with full coverage would pay an inequitable premium.

In an effort to avoid this inequity and to encourage insureds to carry a reasonable amount of insurance in relation to the actual cash value (or replacement value) of their property, a coinsurance requirement is incorporated into many commercial property insurance policies. The insured receives the benefit of a reduced rate when the limit is equal to a specified coinsurance percentage (commonly 80%).

The rates ordinarily used for insuring commercial buildings and personal property are calculated with the assumption that they will be used with an 80% coinsurance provision. When a policy contains a higher coinsurance percentage, the 80% coinsurance rate is reduced to encourage the insured to purchase higher limits. Therefore, with 90% or 100% coinsurance, the insured must purchase a greater amount of insurance to comply with coinsurance, but the rate is reduced. When there is no coinsurance requirement, or when it is less than 80%, the rate is increased.

For the company, encouraging insureds to carry an amount of insurance that more closely approximates the value of their property also helps ensure that sufficient premium will be collected to pay losses as they occur.

For the policyholder, it offers peace of mind that the likelihood of a penalty being imposed in a loss situation is diminished, if not eliminated.

Coinsurance limits the amount the insurer must pay for damaged property to that proportion of the loss that the amount of insurance bears to a specific percentage of the value of the property at the time of loss.

The coinsurance provision in the AAIS Commercial Property policy (CP-12 Ed 1.0) includes an example of how it applies built right into the policy:

If the insured purchases insurance at least equal to the coinsurance percentage (say 80%), the insurer pays the full value of any loss (either replacement cost or actual cash value, depending on what the insured has purchased), up to the limit of insurance. If the insured does not meet the coinsurance requirement, he or she will be penalized in the event of a loss and will become a coinsurer.

Application of deductible

In the AAIS Commercial Property coinsurance provision, the deductible is subtracted from the loss before application of the coinsurance percentage. This yields a larger adjusted claim payable to the insured than if the deductible were subtracted after application of the coinsurance percentage.

Note that it is not mandatory that the insured carry insurance up to the specific percentage, but if the insured does not comply, a penalty will be imposed in the adjustment of the loss. Conversely, if the insured carries insurance that meets the coinsurance percentage, the full value of the loss will be paid up to the policy limit.

Insurance to value requirements in homeowners insurance

The "insurance to value" requirements of the replacement cost provision in a homeowners policy, while technically not coinsurance, are similar to the coinsurance provision in the commercial property policy. The similarity lies in the fact that if the 80% insurance to value requirement is not met, recovery may be based on the proportion of the cost to repair or replace represented by the amount of insurance carried divided by 80% of the replacement cost. Under the homeowners policy, however, the minimum amount received will never be based on an amount that is less than the actual cash value of the property (which can occur with the Commercial Property policy).