Coinsurance -- What is It?

Insurance To Value Requirements Keep Rates Equitable

Wooden blocks spelling Property Value

Many commercial property policies contain a coinsurance clause. This clause imposes a penalty when a policyholder suffers a partial loss and has failed to purchase an adequate limit of insurance.

Insurance to Value

In property insurance, coinsurance is based on the concept of insurance to value, meaning the ratio of your limit of insurance to the value of your insured property. For example, suppose that you own a small office building. After consulting a building contractor, you estimate the replacement cost of your building to be $2 million. If you insure the building for that amount under a commercial property policy, your insurance to value ratio will be 100%. Alternatively, if you insure the building for $1.8 million, your insurance to value ratio will be 90%.

Purpose of Coinsurance

Coinsurance clauses encourage businesses to buy adequate insurance. Most property insurance claims involve partial losses. If coinsurance clauses did not exist, many policyholders would try to save money on premiums by insuring their property for only a portion of its value. These policyholders would have insufficient insurance to cover large losses.

A primary function of commercial property insurance is to protect businesses against catastrophic losses, such as the total destruction of a company-owned building. For many businesses, the loss of a building would be devastating. If the building isn't insured for its full value, the business might lack enough funds to reconstruct the building. This could impact the company's ability to survive.

Coinsurance clauses encourage policyholders to insure their property at or near its full value. When most policyholders buy full limits of insurance, insurers collect more premium dollars and can charge lower rates overall. This helps ensure property rates are equitable.

How It Works

Coinsurance works by imposing a penalty on policyholders that fail to purchase enough insurance to satisfy the coinsurance percentage shown in the declarations. The penalty applies to partial losses only. It is not relevant to total losses.

The coinsurance clause will have no effect until you suffer a property loss. When the loss occurs, the insurer will compare the limit of insurance on your policy to the amount of insurance you are required to purchase based on the coinsurance percentage. If the ratio is less than 1, you will be subject to a penalty.

In a commercial property policy, the coinsurance clause is typically found in the policy Conditions section. The fact that your policy contains such a clause does not mean that your policy is subject to coinsurance. Coinsurance applies only if a coinsurance percentage is shown in the policy declarations.

Example

Suppose that "80% coinsurance" appears in the declarations of your commercial property policy. The following example demonstrates what this means.

You own a building that will cost $1 million to replace. Because the coinsurance percentage is 80, you must insure your building for at least $800,000 (80% of $1 million) to avoid a penalty. You want to save money on insurance premiums so you insure your building for only $700,000. Your policy has a $5000 deductible.

A fire breaks out in your building and causes damage that costs $200,000 to repair. At the time of the loss, your limit of insurance was $700,000. To satisfy the 80% coinsurance requirement, you needed to purchase at least $800,000. The ratio of the amount you carried divided by the amount that was required (700,000 / 800,000) is .875. While your loss was $200,000, your insurer will pay you only $175,000 (200,000 X .875) minus the $5,000 deductible or $170,000. Your coinsurance penalty is $25,000.

Avoiding the Coinsurance Clause

One way to avoid the coinsurance clause is to purchase the agreed value coverage option described in your policy. For this coverage option to apply, you must submit a statement of values to your insurer before the policy begins (or renews). The statement summarizes the value of your insured property. The values may be expressed in terms of replacement cost or actual cash value, whichever you have selected.

Agreed value coverage applies for the term of the policy. To continue the coverage to the following policy period, you must submit a new statement of values before your current policy expires.

Another option for avoiding the coinsurance clause is value reporting. This option applies to personal property only and is typically used by businesses whose property values fluctuate. An example is a ski shop situated in an area popular for winter sports. You can choose quarterly, semi-annual, or monthly reporting. You will pay a deposit premium and then submit reports of your property values at the required intervals.

Other Types of Insurance

Coinsurance is also used in medical and dental insurance. Many health and dental policies cover medical or dental costs according to a specified ratio such as 80/20 or 70/30. The larger number (80% or 70%) represents the percentage paid by the insurer while the smaller number (20% or 30%) is the percentage you must pay.

Coinsurance clauses can be found in some directors and officers and errors and omissions policies. These clauses may require you to pay a portion of any damages award or settlement.