Coinsurance is a flexible term, as it appears in many different types of policies, all in different ways. This article specifically addresses how the Coinsurance clause works in property insurance. This article uses a Homeowner’s policy as an example, but the Coinsurance clause functions identically in commercial property insurance as well.
A Coinsurance clause is a very common provision that can be found in property-covering insurance policies. Coinsurance was created to ensure that the property to be insured is properly valued. Requiring proper valuation makes for better loss modeling and proper premium payments. Additionally, Coinsurance can apply to both Replacement Cost and Actual Cash Value loss settlements.
How Does the Coinsurance Clause Require Property to be Properly Valued?
The Coinsurance clause will require the insured property to be insured for a certain percentage of its total Actual Cash Value/Replacement Cost value. Typically, the Coinsurance percentage will be set at 80% (80% is most common, but the percentage can be changed in most cases). So if the Coinsurance percentage is 80%, a piece of property has to be insured for 80% or more of its total value at the time of a loss, or there will be a 'penalty' applied to the claim settlement. The 'penalty' applies when the insured value doesn't meet the required percentage. When that happens, the insured has to share the loss according to the actual percentage, which effectively makes the insured a co-insurer.
Example of Proper Valuation: Say your home's full Replacement Cost value is $200K. With an 80% Coinsurance clause, you can have it insured for $160K and still have no penalty if a claim occurs (200,000 x 0.8 = 160,000). However, note that the total dollar amount you have the home insured for is the maximum that you would receive after a total loss. So in the same example, if you had your home insured for $160K, you would only receive $160K after a total loss, not the full Replacement Cost value of $200K.
To look at the Coinsurance clause another way, you could say that the 80% Coinsurance allows for a 20% 'buffer zone' for valuation errors, inflation, market shifts, and other factors.
How is the Penalty Calculated?
The penalty, or co-insurance payment, is calculated by taking the amount that the property was insured for and dividing it by what it should have been insured for. The resulting fraction is then multiplied to the total claim/loss amount incurred. The resulting number calculated is the amount you will be receiving for the claim.
Example: Take a home with a total RC value of $200K that is subject to an 80% Coinsurance, but it is insured for $150K at RC valuation.
Insured for: $150,000
Should have been insured for: $160,000 (200K x .8)
Calculated ratio: 0.9375 (150K / 160K)
Loss amount: $50,000
Amount paid by insurer: $46,875 (0.9375 x 50K)
Penalty Amount: $3,125 (50K - 46,875)
(Note that a deductible was not accounted for in this example)
The Bottom Line
If you don't have your property properly insured, come claim time, you might not be able to fully rebuild your house using the insurance money, and/or your claim settlement might get penalized! Always check with your agent to see if your building has been properly valued!
Note: The examples used were insurance policies written with Replacement Cost valuation, as it has the least amount of steps in calculating Coinsurance. The Coinsurance clause also affects claims with property insured at Actual Cash Value. When calculating Coinsurance on an ACV policy, the extra step is accounting for depreciation, which is deducted from the total RC figure. In an ACV example, the Coinsurance percentage would be of the proper depreciated RC amount, and any penalties would be calculated the same method as shown above.