Insured regularly disagree with the amount of insurance they are required to purchase for a piece of property. Of course, the lower the coverage amounts, the lower the overall insurance premium, which is what we are searching for, right?
This disagreement can lead to serious financial peril in the event not enough coverage is purchased for a piece of property. Insurance policies may contain a coinsurance clause in order to attempt to sway an insured to maintain adequate coverage throughout the policy term.
Let’s first take a look at what coinsurance is and does, then look at the consequences of not adhering to the coinsurance clause in your policy, which is the coinsurance penalty.
What is Coinsurance?
Coinsurance, also known as a “coinsurance clause” in an insurance policy, is a requirement (policy condition) that states an insured must carry insurance equal to at least a certain percentage of a property’s actual cash value (ACV). This is done to ensure a piece of property is not underinsured when the replacement cost loss settlement option is purchased.
The necessary coinsurance percentage will vary by insurer and type of coverage, but you can expect to be required to purchase coverage equal to at least 80 to 90 percent of the actual cash value of your property.
Many homeowners insurance companies will calculate their own replacement cost value and only issue a policy if that amount of coverage is purchased. This eliminates the concern of not having enough purchased enough coverage.
In terms we can all understand; the insurer does not want to be in a position to pay to rebuild a piece of property at full replacement cost when the property was only insured for a fraction of its actual cash value.
An extreme example depicting the situation described above would be insuring a building for $100,000 when the ACV was $200,000. An uneducated or unscrupulous insured may attempt to obtain the lower coverage amount to reduce their overall premium, but still expect the property to be rebuilt (if replacement cost coverage was obtained) at a cost of $220,000.
Of course, the insurance company bases their premiums on having detailed and accurate property information. Insurance companies could not stay in business if they were charging too little for insurance and paying out insurance claims for twice the amount of coverage originally purchased.
You will incur a “coinsurance penalty” in the event you suffer a property loss and it is determined you do not have at least the required percentage of coverage. The coinsurance penalty is designed to reduce the amount of a loss payment by the percentage the covered property was underinsured.
Specifically, the coinsurance penalty can be described as the amount of insurance you carry, divided by the amount of insurance you should have carried, multiplied by the amount of your loss, minus any applicable deductibles.
A simpler way to remember the formula is; “did carry over should carry, times loss, minus deductible.”
Let’s look at an example of how a loss would be paid if the coinsurance clause wasn’t met (penalty):
Actual Cash Value of your building at the time of loss: $100,000
Required Coinsurance: 80%, or $80,000 (100,000 x .80 = 80,000)
Amount of Coverage You Carried at time of loss: $60,000
Amount of Loss (perhaps a fire in your home): $30,000
Your deductible: $1,000
Here’s the math:
$60,000 (did carry) – divided by $80,000 (should carry) = ¾ or 75%
75% Multiplied by $30,000 (amount of loss) = $22,500
$22,500 Minus $1,000 (deductible) = $21,500
Your loss payment from the insurer would be $21,500, not the $29,000 you would receive if your coinsurance clause was met (don’t forget the deductible is applied regardless of the coinsurance clause).
This example demonstrates the importance of insuring your property up to at least the coinsurance clause amount on your policy. The penalties can greatly increase as property values go up since we are dealing with percentages rather than flat rates.
Contact your insurance agent or insurer if you are not aware of what your coinsurance clause is or just to make sure you are meeting the requirement.