In my years as an insurance agent, I have found one insurance concept to be a mystery. Sometimes, even the most seasoned insurance professionals find themselves confused. Co-Insurance. How do I explain this term to my commercial clients?
In a commercial insurance scenario, the purpose of coinsurance is to incent the insured to insure their property (whether a building or contents) to value. Most Property losses are not total losses. The best example is to use a commercial building. If you have a $1,000,000 building, chances are, it will never completely burn down or get destroyed in a tornado. But, in the building’s lifetime, there are a ton of smaller things that can happen to it – part of the roof is damaged in a storm, a fire breaks out in a section of the building, an uninsured vehicle crashes into the front of the building, etc. Theoretically, a building owner could insure that $1,000,000 building for only $500,000, since most losses would never exceed that amount. The insurance company would pay multiple small losses, but never collect the correct premium for the risk – so, the insurance industry developed coinsurance.
Coinsurance is the incentive to make the insured purchase the proper amount of coverage. If they underinsure, they will participate in the claim, to the extent that they undervalued the property. The higher the percentage of coinsurance, the lower the premium that is charged. This is because the insured who takes a 100% coinsurance clause is taking the most risk on themselves. The insured is basically saying, I am 100% positive I know what the replacement cost of my building will be, not just today, but AT THE TIME OF LOSS.
When we use an 80% coinsurance percentage, we are saying that we are pretty sure, but not 100%. We get some additional wiggle room and take on less risk. Since the insured is taking less risk, they pay a, slightly, higher premium.
If we have underinsured the building, then we run the risk of triggering the coinsurance penalty. If that is the case, then the insured is much safer with an 80% coinsurance clause instead of 100%. We never use 100% coinsurance because we have NO room for error.
If the true Replacement Cost Value of a building is $1,000,000 and we insure the building for $1,000,000 with 80% coinsurance, we have met the policy/coinsurance requirements and there will be no penalty. If there is a $300,000 loss, the company will pay $300,000 (minus the deductible). If it is a complete loss, the company will pay $1,000,000 (minus the deductible).
If the true Replacement Cost Value is $1.5million and we only insure the building for $1,000,000 at 80% coinsurance, we have a big problem, since we have not met our obligation to insure the building within 80% of the actual RCV of the building – we have triggered the coinsurance penalty by underinsuring the building. If there was a $450,000 loss, the policy would only pay $374,000.
The insured will never be “out of pocket” unless the building is under insured. If the limit on the policy is correct, the policy will pay the entire loss, minus the deductible.
I hope this explanation has helped to de-mystify co-insurance. If you have any questions or would like to discuss, do not hesitate to reach out to me.
