Adequate building valuation and what is coinsurance?
- Bragan Jackson
- Dec 8, 2022
- 6 min read
Updated: Dec 9, 2022
The Risk Sentinel, VOL 1, ISS 2
Ever heard of the word coinsurance? If you have, you probably just had a shiver of chills run down your spine. Would it surprise you to hear me say coinsurance is not something to be feared? What then would you say if I told you coinsurance might be a way you can save some money on your insurance premium?
Before we get into the nitty gritty, pop quiz:
Which coinsurance provision costs more premium, all other things being equal?
80% Coinsurance
90% Coinsurance
100% Coinsurance
Think you got it right? Read on below and let's find out together.
If you're ready to skip ahead, use the links below to navigate between sections in the post:
What is coinsurance?
Coinsurance is a tool that insurance carriers use to ensure that properties they insure are appropriately valued. Basically, if the general public by and large purchased less insurance than is required to replace all of the individual covered items themselves, the insurance carriers rates would be inadequate (or at the very least, less equipped than they would be otherwise) to replace all the covered items in a catastrophic event. This means that the insurance carrier would be less able to pay claims and therefore less desirable to the individual insurance purchaser (in this case, the home or business owner paying the premiums).
One of the most recognized coverage forms in the insurance industry is written and promulgated by Insurance Services Office, Inc. ISO has been around in one form or another since 1971. Today, one of its most recognized functions is providing standardized insurance coverage forms to the insurance industry. While it would be hard to peg exactly what percentage of insurance policies are issued on ISO coverage forms, I'd be willing to bet that if you pulled out a copy of your own insurance policy, you'd see ISO mentioned at least once. Why is that you ask? According to The Balance:
Creating new policy forms is a costly, time-consuming task. Insurers can avoid this task by using pre-printed ISO forms. They can also avoid some of the risks associated with policy writing. Policies drafted by insurers may be interpreted differently by the courts than the insurers intended. ISO forms generally present fewer risks since much of the policy language has already been analyzed by the courts.
So, here's the coinsurance wording from the most common form ISO uses with respect to property insurance: form number CP 00 10 Building and Personal Property Coverage Form:
If a Coinsurance percentage is shown in the Declarations, the following condition applies: a. We will not pay the full amount of any loss if the value of covered Property at the time of loss times the Coinsurance percentage shown for it in the Declarations is greater than the Limit of Insurance for the property. Instead, we will determine the most we will pay using the following steps:
(1) Multiply the value of Covered Property at the time of loss by the Coinsurance percentage; (2) Divide the Limit of Insurance of the property by the figure determined in Step (1); (3) Multiply the total amount of loss, before the application of any deductible, by the figure determined in Step (2); and (4) Subtract the deductible from the figure determined in Step (3). We will pay the amount determined in Step (4) or the Limit of Insurance, whichever is less. For the remainder, you will either have to rely on other insurance or absorb the loss yourself.
To understand what this really means in practice, we'll need to go through some examples.
How does coinsurance in property insurance work?
As we discussed previously, coinsurance is a tool that insurance carriers developed to ensure policyholders purchase the right amount of insurance (i.e. the limit of insurance). It stands to reason then, that there must be a penalty of some kind if the policy IS NOT purchased with the right (or adequate) limit of insurance.
Fortunately we need to look no farther than the ISO coverage form itself:
In the example above, the insured was shorted $20,250 on the loss payment due to the fact that they purchased a $100,000 limit for Building coverage instead of a $200,000 limit. Is your business prepared to foot the bill for an unexpected ~$20,000 after you just had to stop production due to a casualty loss? Most are not.
Let's tweak the example a bit to look at another scenario.
Example 2 (underinsurance):
The value of the property is: $ 250,000
The Coinsurance percentage for it is: 90%
The Limit of Insurance for it is: $ 100,000
The Deductible is: $ 250
The amount of loss is: $ 250,000
$250,000 x 90% = $225,000 (the minimum amount of insurance to meet your Coinsurance requirements)
$100,000 / $225,000 = .444
$250,000 x .444 = $111,000
The adjusted amount of loss is greater than the limit of insurance plus the deductible, therefore, the most we will pay is the limit of insurance.
Now if you find yourself in this position you may be thinking to yourself, "The coinsurance provision didn't even factor in to how much I was paid in Example 2," and you would be right. But let's talk about what really happened here. You just suffered a $250,000 loss and only got reimbursed for $100,000 by your insurance company.
Purchasing adequate limits of insurance
When you first started reading and learning about coinsurance you probably were thinking to yourself, "Great, just another way the insurance company is trying to take my money and pay out less after a claim." Hopefully by the time you got to Example 2 above, you realized that even when there's a coinsurance penalty to be assessed, you might still be paid your full limit of insurance.
So what do we do armed with a knowledge and understanding of how coinsurance works? Hopefully you don't whip out your calculator and start working out how to purchase the exact minimum limit required in order to avoid a coinsurance penalty.
Let's look at one final example:
Example 3 ("adequate" insurance):
The value of the property is: $ 1,000,000
The Coinsurance percentage for it is: 80%
The Limit of Insurance for it is: $ 800,000
The Deductible is: $ 1,000
The amount of loss is: $ 1,000,000
The minimum amount of insurance to meet your Coinsurance requirement is $800,000 ($1,000,000 x 80%). Therefore, the Limit of Insurance in this example is adequate, and no penalty applies. We will pay no more than $800,000 (the limit of insurance).
You'll notice that I've placed 'adequate' in quotation marks for Example 3. I did this to highlight the fact that while the limit purchased was enough to avoid a coinsurance penalty, it was not enough to make the insured whole following their total loss to their million dollar property.
By now you should be thinking about what the real enemy of good insurance is: underinsurance. While coinsurance penalties can be a tough thing to learn from, not purchasing enough insurance in, terms of limit, is the real enemy to both policyholders and insurance carriers alike.
So how does this help me save money?
At the beginning of the post I told you there might be a way to save some money on your insurance. I wasn't making that up - here's the deal:
There are tons of factors working behind the scenes to develop the amount of premium your insurance carrier charges you. It should come as no surprise, then, that what coinsurance percentage you choose affects the final rate. In addition to standardized coverage forms and endorsements, the Insurance Services Office also develops underwriting and rating rules that carriers can choose to subscribe to in what's called the Commercial Lines Manual.
While there are situations where insurance carriers are granted the freedom and flexibility to deviate from the rules and rates issued in the CLM, generally speaking, everyone is playing by the same set of rules. Now that you've seen some examples would you have changed your answer to the opening poll question had you known then, what you know now? We can obviously see now that carriers are willing to offer lower rates in exchange for higher coinsurance percentages.
To close everything out we'll cover one final option not yet discussed: waived coinsurance or "no coinsurance". This can also sometimes be referred to as "Agreed Value" or "Agreed Amount". As we all know, nothing in life is certain so there is a general school of thought that it's probably better to err on the safe side and ask the insurance carrier to drop the coinsurance provision altogether. There are some carriers that may agree to do so, but guess what - that's almost always going to come at an added cost to you, the policyholder.
So at the end of the day, what we're left with is a bunch of choices. Like most things in life, the choices we make have very different sets of consequences.
If you've got follow-up questions, feel free to place them in the comments section below and we'll be happy to answer your question as best we can. Keep in mind, determining whether or not you have adequate limits is a complicated process that requires thorough evaluation. We'd love to help you take that journey. Don't hesitate to reach out to me directly if we can be of service to you. My email address is bjackson@independentriskconsultants.com.
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