Few subjects are more difficult for a client (and at times for an agent) to grasp than the coinsurance feature found in many property policies. Failing to understand the issue can result in serious penalties come claim time.In this article we'll try and make a complicated issue a little easier to understand.
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The Purpose Behind Coinsurance
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The purpose of coinsurance is not to punish an insured for carrying inadequate insurance-to-value, but rather to provide a financial incentive that: (1) encourages them to carry adequate limits in the event of major losses, and (2) rewards them (in many instances) with a significant premium reduction for doing so.If adequate limits of insurance are not carried then a penalty may be applied come claim time.
Why do insureds need an incentive to carry limits of insurance approaching the value of their property?Simple...because most losses are partial and don't result in a total, or even substantial, loss.Without a financial incentive, insureds who are not risk aversive might be inclined to purchase relatively small limits of insurance.
To illustrate, according to one estimate, less than 2% of fire losses are total, and 86% of fire losses result in damages of 20% or less of the building value.That is, if a building is worth $500,000 and a fire occurs, there is an 86% chance that the damage will be $100,000 or less.So, if the insured is a risk taker, why not insure the building for $100,000 or less?
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The Incentive To Carry Adequate Insurance
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OK, it's gets a little more difficult now so hang with us.Insurance companies encourage clients to carry adequate coverage limits by making the rate for coverage decrease as more coverage is purchased.For example, think of it along the lines of someone deciding to purchase a soft drink.If they went to a vending machine they might pay a dollar for one can.….but if they went to a supermarket they could get a six-pack for perhaps $1.99.While they spent more money on six soft drinks than they did on one soft drink, on the whole the "rate per can" was a lot less with the six-pack.It's the same way when someone decides to purchase insurance --- the more they buy the cheaper the rate is.True, purchasing $600,000 of insurance will cost more than purchasing $100,000 of insurance (just like six soft drinks cost more than one soft drink) but on the whole it's a lot better deal for the consumer to purchase more (adequate) insurance.And….we know how people like deals!!
The company rewards the client for buying more insurance by using rates that correspond to various "coinsurance rates."Common coinsurance rates are 80%, 90%, and 100%, and in addition there is a "no coinsurance" rate too.If a policy has an 80% coinsurance requirement that means that the rate is based on the client carrying insurance that's at least 80% of the value of the property.For example, on a $500,000 building with an 80% coinsurance feature the client must carry at least $400,000 of insurance to comply with coinsurance.If they don't they are penalized.
Here's how it's an incentive for the client to carry adequate insurance.The rate for insurance at the 80% coinsurance rate might be 18 cents per hundred dollars of coverage.At 100% coinsurance the rate might be 15 cents per hundred dollars of coverage.If the policy was written at the "no coinsurance" rate the cost per hundred dollars of coverage might be 60 cents.By the way, these rates are just examples used to illustrate the advantage of purchasing adequate insurance and each policy will have its own rates.
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A Rating Example
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You saw how the rate for insurance decreases as the client buys more so let's illustrate this by an example.Suppose we have a $500,000 building and we use the rates above.If the 100% coinsurance rate was used the premium for $500,000 of coverage would be $750(that's $500,000 x .15).If the 80% rate was used and the insured purchased $400,000 of coverage the premium would be $720 ($400,000 x .18). If the "no coinsurance" rate was used and the client decided, for example, to only purchase $100,000 of insurance (after all there is an 86% chance he won't need more than that) the premium would be $600 ($100,000 x .60).So as is shown here, the client can purchase the full amount of insurance required to rebuild the building for not much more that had he purchased only $100,000 of coverage.Said another way, the client can purchase just $100,000 of coverage for $600, but they could buy five times as much insurance for just25% more money.That's almost like buying one soft drink for $1.00 or buying a six-pack for about $1.25 -; we're talking a deal here folks!Maybe the chart below will help to illustrate this:
Office Building
Policy Limit
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No Coinsurance Rate
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80%
Rate
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100%
Rate
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Premium
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$100,000
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0.60
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$600
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$400,000
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0.18
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$720
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$500,000
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0.15
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$750
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The Penalty
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A creative client might look at the chart above and say, "Well heck, just give me $100,000 of coverage on my $500,000 building and let's just use the 100% coinsurance rate."A good idea, but it won't work.A penalty was mentioned earlier, applied if the client fails to comply with the coinsurance provision.In simple terms the penalty states, "If you don't carry the proper amounts of insurance based on coinsurance, then come claim time the policy won't pay your claim in full, even for a partial loss."In effect if the client does not have adequate insurance to meet the coinsurance requirement then they become the "co-insurer" along with the company and participate in the loss too.Here's an example.The client has a $500,000 building and the policy has an 80% coinsurance feature.To avoid a penalty the client must carry insurance of at least 80% of the $500,000 building value, or $400,000 in this case.If the client did that all losses would be paid without penalty, up to the policy limit of $400,000.(Note an important point here ….even though there was no coinsurance penalty the client can still suffer financial consequences in a total loss.It's important to note that the coinsurance feature in insurance policies states a minimum amount of insurance that must be carried, and there is no reason the client can't, and shouldn't, carry more than just the minimum required.) For this example let's suppose that the client carried only $100,000 of coverage.It should be easy to see that the client is carrying only one-fourth of the insurance required by the coinsurance feature.The client did carry $100,000 and should have carried $400,000 (or more) to avoid a coinsurance penalty.Now suppose there is a "minor" $40,000 fire at the client's building.Even though the client may think, "I have $100,000 of insurance and only a $40,000 fire" it should be easy to see that there is about to be a penalty for underinsurance.Since the client carried one-fourth of the insurance required by coinsurance, the policy will cover only one-fourth of the claim.In this example the policy pays $10,000 of the $40,000 claim and then the insurance company still applies a deductible.The bottom line is the client is not going to be happy at all.In insurance circles you may hear this math process referred to as, "Did over should times the loss."That simply means that you divide the amount of insurance the client "did carry" by what they "should have carried."Multiply that result by the loss and you have what's owed, before deductible.
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How Much Insurance to Carry
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Remember earlier how we discussed how much coverage the client had to buy in order to avoid a coinsurance penalty?That was the minimum the client had to buy, and we stated that the client could buy more than the minimum.The best recommendation for a client is that they purchase enough coverage to rebuild the building at today's replacement cost.(By the way, coinsurance applies to personal property too, but we'll just discuss the building here since the principles are the same.)That means the insurance policy should have coverage that is at least 100% of the estimated replacement cost of the building.When you think about that statement it really makes sense because if the client has a total loss to a building they will want enough insurance to completely rebuild it.If they don't have that amount of coverage then they are left having to use their own funds to rebuild the building.
So now what we have are two questions to answer.The first question is, "How much insurance does the client buy?"As we stated above that's pretty easy --- just buy 100% of the replacement cost of the building.The second question is, "What coinsurance percentage should be used for the policy?"We hope you didn't beam up there because that second question might have thrown you.Remember, there are two separate questions that must be answered for the insurance company to issue a policy.The policy can be written for any amount of insurance the client wants, and a variety of different coinsurance percentages can be used.If our recommendation of purchasing 100% of the building replacement cost is followed the only question left is to decide what coinsurance percentage to use.Remember, the higher the coinsurance percentage, the lower the rate for insurance.
Let's continue to use our $500,000 building as an example, and assume the client wanted to adequately insure the building against a total loss.In such case they would purchase $500,000 of coverage.In selecting a coinsurance percentage they would have choices of no coinsurance, 80%, 90%, or 100%.The premium would of course be the lowest if the client selected the 100% coinsurance rate and the highest at the "no coinsurance" rate.For example, if we used our rates from the chart above at the 80% coinsurance rate the premium would be $900 ($500,000 x .18) and at the 100% coinsurance rate the premium would be $750 ($500,000 x .15). A typical client would see this and say, "Well, let's just use the 100% coinsurance rates." However, there is a downside to insuring for 100% of the building value and also selecting 100% coinsurance in order the get the lowest rate.
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The Danger of 100% Coinsurance
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Sticking with our example of the $500,000 building with $500,000 of coverage and a 100% coinsurance feature here's the danger.Suppose that the agent does not update the building coverage each year.Or, suppose the client underestimated the value of the building and instead of it being $500,000 to replace it, the actual cost was really $550,000.What you'd have in both cases is a building that has a replacement cost of over $500,000 but you'd have only $500,000 of coverage.With a 100% coinsurance feature the policy states that at the time of the loss the insurance must be 100% of the replacement cost of the building.Obviously there is a problem because there is not adequate insurance and the client finds himself falling victim to the coinsurance penalty we addressed above.
If the policy had been written, for example, at 80% coinsurance rates and $500,000 of coverage was provided there would not be a problem if the building value in our example was $550,000.Here's why --- with a $550,000 building and an 80% coinsurance feature in effect the client must carry 80% of $550,000 on the policy.The math breaks down to the client having to carry at least $440,000 in order to avoid penalty.With $500,000 of coverage in place as our example used, the client is still within the "wiggle room" to avoid penalty.Even if a 90% coinsurance feature was in effect the client would need to carry only $495,000 on the $550,000 building to avoid penalty, something that was done in the example.
As you can see, writing insurance equal to 100% of the replacement cost when 100% coinsurance rates are used leaves no room for error.If the building value increases and the insurance amount does then not the client is underinsured.Likewise, if the estimated replacement cost of the building was incorrect when an amount of insurance was selected the client faces underinsurance and a possible coinsurance penalty.
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Doing Your Best to Avoid the Coinsurance Penalty
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Since the thought of a coinsurance penalty is not a good one for the client or agent, here are some ways to avoid it.
First, make certain the absolute best information is used to determine the replacement cost of the building.Qualified building inspectors or local contractors can be an asset in accomplishing this.Without an accurate building replacement cost the potential for underisnurance is always there.
Next, write 100% of the replacement cost that's been determined. If three different sources were consulted in determining the replacement cost there would no doubt be three different replacement cost estimates.In such case it's best to err on the side of caution and select the highest amount since it's better to have a little too much insurance than to come up short at claim time.
Then, select a coinsurance percentage less than 100% --- this gives the "wiggle room" we mentioned earlier.A good compromise is to use the 90% coinsurance since the rate for coverage is less than using the 80% rate and a whole lot lower than the "no coinsurance" rate.Remember though--- the client still purchases an amount of insurance that's at least 100% of the replacement cost of the building.(Remember our two questions we discussed above!)
Then, make sure the values stay current.Each year adjust the building coverage up to account for inflation.If additions are made to the building that increase the replacement cost the amount of insurance needs to be increased immediately.This means the agent and client need to talk on a regular basis, at least every year and more often if vales are changing.
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Avoiding the Coinsurance Problem Entirely
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If you're still with us, and we hope you are, you may be thinking, "Man-oh-man, I wish I could make this whole coinsurance problem go away and put the issue to bed at the time the policy is purchased.Can we make that happen?" Well, while we can't make the whole problem go away entirely, there is a way to lessen the risk of underinsurance and/or penalty come claim time.Properly used an option called "Agreed Value" can help the client avoid a penalty come claim time.But since your brain is toast now we will save that discussion for another day.You can see that article in the FAIA Education Library, appropriately titled "Agreed Value Loss Settlement Option."
So, how'd we do?Are you ready to go out and face the world --- hit the late night TV shows and explain coinsurance?We hope so!
Copyright © Florida Association of Insurance Agents, February, 2001.This article contains copyrighted material from the Independent Insurance Agents of America Virtual University, used with permission.For comments about this article contact David Thompson at FAIA.
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