Co-insurance is a term used in many areas of insurance claims. It is an insurance term that describes the spreading of the risk between the insurance company and the insured for costs incurred after the deductible. The insurance agency may accept and rate the risk based on the numbers given. The insurance claims professional (also known as the claims adjuster) may determine the replacement value when the claim is incurred and ultimately reported to the insurance company. There is a specific formula outlined in the policy of which we will discuss in this article. The purpose of coinsurance is to avoid an imbalance between the insurance company and the policyholder. It also encourages insureds to carry a reasonable amount of insurance in relation to the replacement value (or actual cash value, depending on which basis the policy is written) of their property.
In policy declarations where 80% insurance to value is listed and the insured’s evaluation is not insured within 80% of the full replacement cost there is a “coinsurance penalty.”
Coinsurance is a penalty forced onto the insured by the insurance carrier for under reporting the value of the physical property. This can also be applied to business income. The penalty is based on a percentage stated within the policy and the amount under reported and ultimately insured.
One of the more unpleasant situations confronting insurance agents and adjusters after a property loss is having to tell the insured that he or she is underinsured and will be assessed a penalty in the adjustment of the claim. Ideally, the time to discuss coinsurance or insurance to value with the insured is before the loss, rather than after it has occurred. Many times the controversy begins whether the proper steps were taken to arrive at the accurate replacement value for the building.
The assumptions is that most building property losses are partially damaged and do not result in the total destruction of the structure. There may be a tendency to gamble the odds and limit the amount of insurance. 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 typically requires that the property be insured for at least an amount that will cover the balance of the mortgage.
A 20,000 square foot building valued at $1 mil has an 80% coinsurance clause. The insured claimed a value of the building for only $750,000. The building suffers a major fire loss. The property adjuster’s evaluation is less than 80% of its actual replacement cost value, when it suffers a loss, the insurance insured will be subject to the penalty. For example, if it suffers a $200,000 loss (after deductible), the insured would recover: $750,000 ÷ (0.80 × 1,000,000) × 200,000 (after deductible) = $187,500.
In this situation, co insurance penalty would be $12,500. Note the deductible comes off before the penalty.
The most commonly issued coinsurance percentage would be 80%. However, it is not uncommon to be 90% and rare but possible as high as 100%. Having a 100% co insurance would impose the greatest penalty for being uninsured. For this reason, it is critical for values of property to be accurately reported annually to reflect inflation and other increases in cost.
Why do insurance carriers place a coinsurance requirement?
The reason that the carriers require”insurance to value" is failure to do so can create underwriting losses for the insurance carrier. The rates would not reflect the risk exposure creating an adverse solvency exposure for the carrier.
The coinsurance clauses deal with property insurance and not liability insurance. In liability the insured sets their desired limits and when that amount is exhausted the insured assumes the remaining of the risk. The insured can pick the desired amount which is directly related to the associated premium. It is the property insurance whereby there are more requirements and limitations.
The simple formula for determining the coinsurance penalty is to take the amount that the policyholder insured the property for divided by the amount the policyholder should have insured the property for times the total amount of the loss. If there is a deductible on the policy than the deductible also needs to be considered within the formula. Again the deductible comes out of the loss prior to applying the penalty.
Why is the deductible subtracted before the coinsurance percentage?
When the deductible is subtracted from the loss before application of the coinsurance percentage, this yields a slightly larger adjusted claim payable to the insured than if the deductible were subtracted after application of the coinsurance percentage. Usually most property insurance policies, clearly state when the deductible is to be applied.
The formula states:
(Insurance carried / Insurance required) x Loss (after deductible) = Amount of Recovery
As another example:
The insured had a building that the replacement cost value “RCV” is worth $100,000 to replace it and the insured have an 80% coinsurance clause. The insured needed to insure the building for at least $80,000 or more. In our example let's assume that the insured had a $10,000 building fire loss. Let us also assume that the policyholder insured the building for $40,000. In this loss the policyholder insured the building for, $40,000, and divides that by what the insured should have ensured the building for (i.e. $80,000). This would equal 50% times the loss of $10,000. So if the insured have a $10,000 fire claim on the insured’s building the policyholder would have the deductible removed first and then the remaining penalty would be applied. Because the insured did not insurance value the insured are a co-insurer of the loss alongside the insurance company.
With many policies, however, the minimum amount received will never be based on an amount that is less than the actual cash value of the property. This is common on many policies to include the commercial property policy.
If the "limit" on the damaged building is less than 80 percent of its replacement cost at the time of loss, the larger of the following amounts will be paid, but not more than the limit shown on the policy declarations page:
- The actual cash value “ACV” at the time of the loss; or
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percentage of the cost to repair or replace, after the deductible and without depreciation on the damaged part of the building in comparison to the 80 percent of the full current replacement cost of the building.
If the "limit" on the damaged building is 80 percent or more of its replacement cost at the time of loss, the smaller of the following amounts will be paid:
- The limit of liability applying to the building;
- The replacement cost of that part of the building damaged with like kind and quality material for like use; or
- The amount actually spent to repair or replace the damaged building.
Please know that the policy holder is not required to rebuild at the same location. The named insured may elect to rebuild elsewhere. However, the most the insured can recover is the cost to build at the original location. Other financial impacts to the insured may be applied unrelated to this article if the building is not rebuilt at its current location.
Author: Partners of Claims Resources and Solutions LLC publishes this article as a public service. It is provided for general information and is not intended to replace legal advice for specific cases.