The Mechanics of Coinsurance

The percentage that they choose is called the "coinsurance percentage." The insured and the insurance company are co-insuring the property because the percentage that the insured chooses not to insure represents the amount of coverage that the insured is insuring.

In order to encourage insureds to insure a reasonably high percentage of their property's value, the coverage form provides the incentive of the coverage extensions to insureds who choose at least an 80 percent coinsurance percentage.

The first additional condition explains how coinsurance works:

1. Coinsurance

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.

The limit of insurance has to satisfy the coinsurance percentage in order for the full amount of any covered loss to be paid.

For example, consider the insured who chose an 80 percent coinsurance percentage and a coverage limit of $220,000. After a loss the company adjuster determined that the full ACV of the property was $250,000. Did the insured meet the coinsurance requirement?

ANSWER: Yes. Eighty percent of $250,000 is $200,000. The insured's limit was $220,000.

If the insured carried only $100,000 coverage would he have met his coinsurance requirement?

ANSWER: No. Obviously, $100,000 is less than $200,000.

The first paragraph of the additional condition on the coinsurance told us that unless the insured complied with the chosen coinsurance requirement, a loss will not be fully paid. The second paragraph of the coinsurance condition tells us how much of such a loss will be paid. It provides the formula in four steps:

The insurer determines the most it will pay using the following steps:

1. Multiply the value of covered property at the time of loss by the coinsurance percentage: $250,000 x 80% = $200,000.

2. Divide the Limit of Insurance of the property by the figure determined in step (1) $100,000/200,000 = .50

3. Multiply the total amount of the covered loss, before the application of any deductible, by the figure determined in step (2); and if the covered loss amounted to $40,000, then step (3) would be: $40,000 x .50 = $20,000.

4. Subtract the deductible from the figure determined in step (3). If the insured's deductible was $250, then step (4) would be: $20,000 – $250 = $19,750.

The amount determined in step (4) is the most the insurer will pay. For the remainder, the insured will either have to rely on other insurance or absorb the loss himself.

The authors of the ISO form wanted to make the coinsurance methodology very clear, so they put in the form three coinsurance examples, the first of which is outlined above. The remaining examples in the coverage form are outlined below.

Notice that the deductible is subtracted from the adjusted loss. The deductible subtraction is the last step in the coinsurance process. This is somewhat different from forms that were in use earlier. The new methodology is less advantageous to the insured and is more reason to make sure that the coverage limit satisfies the coinsurance requirement.

When an insured, usually with the assistance of an insurance agent or broker, determines the coverage limit of a policy he is almost always thinking in terms of current values. A building that has an actual cash value today of $500,000 must be insured to $450,000 in order to meet a 90 percent coinsurance requirement and have losses fully covered (minus the deductible, of course). If a covered loss occurs in the latter part of the coverage term, it is possible that the ACV of the building may have risen. It might be $550,000 by then. Similarly, the value may have reduced. Regardless, the coinsurance clause is applied at the "time of loss."

The insured will not profit nor will the insured obtain a reduced premium if his building's value is reduced. He will, however, recover more of his full loss.

The coinsurance clause does not always cause a penalty. For example, in a situation where the loss is severe, or total, the insured may recover the full policy limit even after application of the policy limit. Consider the following example:

When:

• The value of the property is $250,000
• The coinsurance percentage for it is 80%
• The Limit of Insurance for it is $100,000
• The deductible is $250
• The amount of loss is $250,000

Step (1): $250,000 x 80% = $200,000 (the minimum amount of insurance to meet your coinsurance requirements)

Step (2): $100,000 / $200,000 = .50

Step (3): $250,000 x .50 = $125,000.

Step (4): $125,000 – $250 = $124,750.

The insurer will pay the $100,000 limit of liability of the policy. Regardless of the application of the coinsurance clause, the amount recoverable is still more than the policy limit and the insured collects that limit. The insured, however, must make up the difference between the limit and the amount of loss.

Note, not only does the insured recover the entire policy limit, but also is not required to pay the deductible because the adjusted loss less the deductible still exceeds the policy limit.

Coinsurance clauses have two purposes. They give the insured an incentive to insure property up to its true value by causing the insured to self-insure a part of the risk if proper limits are not acquired. It protects insurers against insureds who attempt to avoid appropriate premiums. Insurance is a business of utmost good faith. The self-insurance created by a coinsurance clause is not a penalty, it is a way of enforcing the promise made by the insured at the time the policy was acquired that insurance equal to the true value of the policy was acquired.

Excerpted from the Insurance Claims Coverage Guide book.