Coinsurance – Don’t Get Hurt by What You Don’t Know

1-800 numbers and online quotes are great if you know exactly what you want and need. But, when you dive into the details after a claim occurs, usually you’re met with disappointment in terms of what the insurance company is willing to offer you for your claim. An agent can make sure this doesn’t happen.

Coinsurance is one of the most confusing and misunderstood concepts in the insurance world. Even the term “coinsurance” has multiple definitions within the industry.

For example, coinsurance for health insurance is drastically different (and arguably easier to understand) than coinsurance in the property & casualty insurance market.

To add another layer of meaning—and complication—a coinsurance clause can appear an all types of policies, from homeowners to commercial property to business income and more. The use and impact, however, of coinsurance varies greatly within each policy type.

Coinsurance – What’s the Best Move?

An agent always hopes their insureds read and understand their insurance policies, but we’re realistic—we know your idea of a relaxing evening doesn’t involve reading half a trees worth of paper on coverages and rates.

If you did take on the endeavor, you’d be greeted by a complex legal document outlining several policyholder (this is you) responsibilities, one of which is coinsurance.

Scared yet? Don’t be—we’re here to help.

What is coinsurance?

Coinsurance may be a familiar topic to you, especially in terms of health insurance. It’s used as a means of sharing risk between insured and insurer, with the goal of lowering the cost of the insured’s monthly premium.

For example, your health insurance plan contains a 20% coinsurance clause, meaning the company pays 80% of your copay (bill) and you (the insured) pay the 20% that remains. If you were billed $1,000 by your doctor, the insurance company would pay $800, and you’d be responsible for the remaining $200. Makes sense, right?

Now it’s time to turn that simple definition on its head by looking at coinsurance for homeowners, commercial property, and business insurance. If you have a policy that insures a piece of property, you can usually expect it to include a coinsurance clause. These types of policies are standard building, business personal property, and even homeowner policies.

Ready for one more curveball? In the property and casualty world, coinsurance has yet another function and meaning.

Technically speaking, the International Risk Management Institute considers coinsurance to be:

“A property insurance provision that penalizes the insured’s loss recovery if the limit of insurance purchased by the insured is not at least equal to a specified percentage (commonly 80 percent) of the value of the insured property. The coinsurance provision specifies that the insured will recover no more than the following: the amount of the loss multiplied by the ratio of the amount of insurance purchased (the limit of insurance) to the amount of insurance required (the value of the property on the date of loss multiplied by the coinsurance percentage), less the deductible.”

Clear as mud, no?

Let’s break it down: if you don’t have adequate insurance coverage on whatever it is you’re insuring, your policy’s coinsurance clause allows your insurance company to penalize you by reducing the amount you can earn if you receive a claim payment.

If your policy declarations page has a percentage (i.e. 80%, 90% or 100%) listed next to the limits for your building, personal property, or business interruption, then that policy contains a coinsurance clause. What does that mean? Basically, you have made a promise to your insurance company that your coverage limits are at least equal to the specified percentage of the cost of replacing whatever it is you’re insuring (your actual replacement value).

Usually, the required amount of insurance must be equal to 80% of the replacement value of the property, but in some cases, that percentage can be as high as 100%. It may seem that paying to insure 100% of actual replacement value is better than paying for 80%, the truth is actually the opposite.

If you select 100% coinsurance you’ve effectively promised the insurance company that the replacement value you selected is 100% accurate. You’ve left yourself no room for adjustments.

Therefore, it’s vital to report property values annually to make sure your policy stays updated and accurate, and that it reflects inflation and other increases in cost.

Avoid Costly Penalties: Learn How to Calculate Coinsurance

Put simply, the coinsurance provision in a property policy requires the policyholder to carry a limit of insurance equal to a specified percentage of the property’s value. This ensures the policyholder will receive full payment at the time of a loss. The following real-life example should help.

Coinsurance will never increase the payment on a property claim—it can only reduce the settlement, or in the best-case scenario, not impact the claim settlement amount at all.

Let’s use the following assumptions for illustration purposes:

• Your building has a value of $1,000,000
• The policy you have covering this building has an 80% coinsurance clause.

Based on those assumptions, you must insure your building for at least $800,000 to avoid a coinsurance penalty at time of loss.

If there’s a claim, the following formula is used to determine recovery:

Value of the property x Coinsurance percentage = Minimum insurance amount required

Here’s where that simple formula gets a bit more complicated: this formula is based on the property’s replacement value at the time of loss. If the replacement amount is less than the coinsurance percentage, a penalty is applied. This penalty reduces the claim payment.

Let’s make another assumption. Instead of insuring your building for $800,000, you decided that $600,000 is adequate coverage. Now you have a fire that causes $200,000 in damages. Since you have $600,000 of coverage and the claim is only for $200,000 worth of damages, you’re covered, right?

Unfortunately, no.

Property claims are calculated by dividing the amount of insurance purchased by the amount that should have been purchased (based on the coinsurance percentage selected). In this case, you purchased $600,000 worth of coverage when you should have purchased $800,000. To determine what the policyholder will receive in the event of a claim, this factor (75 percent) is multiplied by the amount of the loss ($200,000 x .75 = $150,000). When all is said and done, purchasing $600,000 worth of coverage when you should have purchased $800,000 results in you receiving only $150,000 (less any deductible) as your payment—for a $200,000 claim. Now you’re $50,000 short on funds needed for full repairs.

Additional examples of coinsurance in action

Scenario 1: Coinsurance requirement IS NOT satisfied

Facts at the time of the loss:

• Total limit of insurance = $51,100
• Coinsurance amount = 80%
• Deductible amount = $1,000
• $20,000 claim to replace the roof and siding due to hail damage

We’ll go through each of the steps to determine the final claim settlement amount.

Evaluation Process

Step 1:

The insurance contract states that the insurance company first determines the replacement value of the property at the time the of the loss. In this example, the property value was $149,000.

Step 2:

Next, multiply the value of the property (determined in step 1) by the coinsurance percentage listed in the policy:
$149,000 x 80% = $119,200.

Step 3:

Now we divide the limit of insurance shown in the policy ($51,100) by the figure determined in step 2:
$51,100 ÷ $119,200 = 42.9%.

Step 4:

Multiply the total amount of the claim by the percentage determined in step 3:
$20,000 x 42.9% = $8,580.

Step 5:

Subtract the deductible amount from the amount determined in step 4:
$8,580 – $1,000 = $7,580.

Results:

If the property is severely underinsured at the time of loss—policy coverage amounts do not meet the coinsurance requirement—claim payments can be drastically reduced.

What appeared to be a straightforward $20,000 loss for which the policyholder should have been reimbursed $19,000 ($20,000 less the $1,000 deductible), instead ended up being an expensive claim for which the policyholder was reimbursed by less than half of the cost of damages (only $7,580).

The difference of $11,420 is the penalty amount incurred for carrying inadequate limits of coverage that are do not represent the actual replacement cost.

Scenario 2: Coinsurance requirement IS satisfied

Facts at the time of the loss:

• Total limit of insurance = $290,000
• Coinsurance amount = 90%
• Deductible amount = $1,000
• $20,000 claim to replace and repair the damage

Evaluation process:

Step 1:

The insurance contract states that the insurance company first determines the replacement value of the property at the time of the loss. In this example, the property had a value of $300,000.

Step 2:

The next step is to multiply the value of the property (determined in step 1) by the coinsurance percentage listed in the policy:
$300,000 x 90% = $270,000.

Step 3:
We see now that the amount of coverage in place ($290,000) exceeds the minimum amount required ($270,000). Therefore, the coinsurance requirement has been met. This time, the coinsurance provision of the policy has no impact on the final claim settlement amount—the best case scenario when applying the coinsurance provision.

Results:

Since the building coverage limit meets the minimum amount of insurance required by the coinsurance clause, the amount due to be paid out in the event of a claim is not affected. The amount payable based on replacement cost is $19,000 ($20,000 claim less the $1,000 deductible).

Why do policies have the coinsurance provision?

Contrary to popular belief, the coinsurance provision does not exist to punish policyholders or give insurance companies a loophole that allows them to pay less than the full value of a claim. Coinsurance is really used to encourage the insured to carry an appropriate amount of insurance in relation to their property’s value, especially on replacement cost policies.

If policyholders try to save premium dollars by insuring their property for less than the specified coinsurance percentage of their property, they effectively become coinsurers for any loss. This means they choose to share financial responsibility for recovering the loss.

Insurance rates are based on a number of assumptions, perhaps the most significant being projected losses. A second significant assumption insurance companies make when determining rates is that every insured will select enough insurance—dollar-wise—to cover the entire value of an insured property.

However, some insureds will figure that most losses are small and that a “total loss” rarely occurs. They’re not wrong—statistics prove this to be true. These insureds choose to insure the property for less than its value. As a result, the insurance company receives less premium than is expected.

The problem? When a major or total loss does occur, there isn’t enough premium reserved to reimburse the insured for the full amount of the claim.

So, when an insurance company requires insureds to insure to a certain value, the companies are actually making provisions to distinguish between people who do insure to the full value versus those who insure at a lower amount. Those who insure to full value are rewarded with a full payout, and those who don’t are penalized.

The insurance company’s reasoning? If you’re willing to insure for less than full value, you’re choosing to share in the losses. Each policy sets a coinsurance percentage, frequently 80, that is the basis for loss sharing. If the insured maintains insurance to the required percent, no loss sharing is necessary.

On a broader scale, coinsurance is critical because statistics show that if less than 80% of the replacement value is covered, insurance companies would not collect enough premium to pay all the claims that clients are due when a disaster strikes.

Think of it this way, you go out to dinner with a large group of friends, but there is only one bill for the entire group. Everyone agrees to contribute their fair share to cover the charges. If only some people contribute their share of the bill, there won’t be enough money to pay for the dinner. Insurance operates the same way.

Insurance companies estimate what their claims and expenses will be in the short-term and using this information, calculate the amount insured’s need to pay to cover the claims and expenses necessary to keep the insurance company in business. If some of the insureds don’t buy a sufficient amount of coverage, the necessary amount of money to cover all claims that might arise won’t be there when the time comes.

What’s the Coinsurance Penalty Solution?

Never insure your property at an amount less than coinsurance requirement. In fact, there’s no reason not to insure the property at its full replacement value—the additional premium required is usually negligible.

Too often, agents try to gain clients and cut policy costs by reducing the coverage offered. It may not be a big deal, and chances are clients may even be comfortable with the lower coverage limits the agent is recommending. After all, aren’t they the expert? However, in the event of a claim, those small savings can severely impact your coverage.

Talk with your insurance advisor about your options. The coinsurance details found in the “Conditions” section of your policy may seem like harmless “fine print”. But in this case, the fine print is critical; if you don’t understand what its saying, ask your advisor to explain it to you.

» Download Free Ebook: The Costly Coinsurance Penalty

Why Your Insurance Agent is Your Ally

We’ve barely scratched the surface of the complex world of insurance, but since understanding the coinsurance provision is one of the major pitfalls we discover most often when working with new clients, this was a good place to start.

No one wants to overspend for insurance coverage, but the right insurance protection is invaluable to the success of your business, or the ability for your family to recover after a catastrophic loss. Without it, you’re one claim away from closing your doors or having your personal finances ruined.