Summary: It is often difficult to explain to your insureds the rationale behind the use of a coinsurance clause in a commercial property or inland marine insurance policy. The noninsurance person has a hard enough time understanding the mechanics of the coinsurance clause, let alone appreciating the need for the clause in the first place.
The scenario presented below was first published in the National Underwriter weekly magazine in October 1995. It sets forth in a simple way the reasons the insurance industry created the coinsurance requirement in the beginning of insurance time.
The typical insured does not like to be forced into buying more insurance than he or she thinks necessary. This presentation will help them understand the need for the gentle coercion found in the coinsurance clause.
Topics Covered:
A sales call
Why coinsurance?
A Sales Call
You are sitting in a prospective insured's office presenting a property and casualty quote to the president of the company. It is a nice little piece of business, generating about $25,000 in total annual premium. Everything goes smoothly until you get to the property section.
Your prospect's current insurance program shows the building and its contents covered on a specific basis with separate limits and an 80 percent coinsurance clause. You are recommending blanket coverage, with a 90 percent coinsurance requirement.
You have no trouble recounting the benefits of blanket coverage compared to separate limits for the building and personal property. The prospect, however, insists on knowing why she must increase her coinsurance percentage from 80 to 90 percent. You discover that she does not want to hear the explanation that the commercial lines manual requires 90 percent coinsurance for blanket coverage.
Her question is deeper. She wants to know why there has to be a coinsurance requirement in the first place. Why can she not insure her building and its contents for whatever value she chooses without worrying about a coinsurance penalty?
Warming to the subject, she says that having a coinsurance requirement in the insurance policy is as bad as being subjected to government meddling in her private business affairs. The government tries to tell her what is good for her, as if she could not figure it out for herself. She goes on to say that Congress is making progress in getting the feds out of her hair. When that is finished, she vows, insurance companies will be next.
Other than agreeing with her that insurance companies ought to be put in their place and that you are a victim of the system just as she is (which a good salesperson might do), how would you explain the rationale for the coinsurance clause so that your hard-headed prospect will accept the concept of coinsurance as good business sense?
Why Coinsurance?
“Coinsurance,” you begin, “is a commercial property (and inland marine) policy provision in which the insurance company agrees to a lower insurance rate per $100 of coverage as long as the insured maintains insurance at a specified percentage of the total insured property value.”
Her eyes are glazing over already.
You try again. “The coinsurance clause is a device designed to induce you to buy more insurance than you might otherwise buy in exchange for a lower per-unit cost for the insurance.”
“Just what I thought,” she yawns. “You're forcing me to act against my will.”
You plod on. “The coinsurance clause benefits you in two ways. First, requiring a certain minimum limit of coverage helps you avoid being underinsured for a major loss.”
“There you go again,” her eyes brightening a little. “That reason smacks of insurance company meddling—paternalism. If I want to take the risk of being underinsured for a large loss, that should be my decision. Let me decide and I'll live or die by my decision.”
“Second,” you raise a finger to cut her off, “coinsurance establishes a basic fairness in premium rates, particularly respecting partial losses, which are the size of loss most likely to occur.” Pleased with your verbal deftness, you continue. “Let's look at some hard numbers.”
“Assume that two manufacturers each buy insurance on their business property, without coinsurance requirements, at a rate of $1.00 for every $100 of insurance bought. Each manufacturer's property is valued at $250,000, but the first one buys a limit of $200,000 while the other carries only $50,000.”
“At the $1.00 rate, the first insured pays a premium of $2,000 while the second pays only $500. If the two manufacturers each suffer a $25,000 loss, both would be fully covered. However, the first would have paid four times the premium of the second for the same coverage on that loss.”
“So the first guy was stupid,” she says. “Why should I have to pay for his stupidity?”
Touching a finger to pursed lips in a knowing way, you continue. “The second manufacturer feels comfortable buying only $50,000 of insurance on a $250,000 building, because he knows that most property losses are small in relation to the total value of the property insured. He had read about a study that found that 75 percent of insured property losses amount to only 10 percent or less of the value of the insured property.”
“On the other end of the scale, the same study found that only 1.7 percent of the losses exceeded 80 percent of the property's value. The study showed that a prudent businessperson could insure his or her property for 50 percent of its total value and be 95.5 percent certain that, if an insured loss occurred, it would be fully covered.”
“There you are,” she snaps. “A smart person would buy limits at 50 percent of total value.”
“True,” you agree. “But look what happens.”
“If a majority of insureds chose limits at 50 percent of value, premiums paid to insurance companies would be drastically reduced. Yet their losses would not be lowered materially because 95.5 percent of property losses are 50 percent or less of the property's total value. Loss ratios would reach 100 percent or more. Eventually insurance companies would have to raise property rates.”
“Look at it this way,” you urge. “Assume that all the fire losses in a given territory are expected to equal $1 million annually. To cover those losses, the insurance industry knows it must collect $1 million plus enough to offset expenses and earn a profit, totaling, say, $1.3 million.”
“If the total value of property in the territory is $1 billion, and the insureds purchase only $100 million of insurance (10 percent of the total value), then the insurance industry must charge a rate of $1.30 per $100 of insurance to collect the $1.3 million needed to pay losses, cover expenses, and earn a profit.”
“However, if the insurance industry required everyone to buy coverage equaling 80 percent of total property value ($800 million is 80 percent of $1 billion), it would have to charge only $.165 per $100 of insurance to recover the $1.3 million it needs to operate ($.165 times $800 million divided by 100).”
“For the same premium, an insured can now purchase eight times as much insurance coverage at a $.165 rate as it can at a rate of $1.30. At the lower rate, not only are the common partial losses covered, the infrequent but devastating large losses are mostly covered too.”
“Pretty clever,” she concedes. “Policyholders are coerced into doing something for their own good.”
“That's right.” You are relieved to have reached her, but you can't stop. You take a chance with one more point.
“Theoretically, insureds can choose not to include a coinsurance clause in their insurance contract, but the insurer would have to raise the rate high enough to equal the rate the insurance industry as a whole would need to generate the premium to cover its losses, expenses, and profit if every insured went without coinsurance.”
For the first time she smiles, and you know you have won a new account.