Coinsurance is the Insured’s Friend

Coinsurance. For some of us, that’s one of the worst words that I could write. You’re already mad at me and you haven’t even read the first paragraphs. For many of us, it’s a word that you barely noticed. You’ve been told that coinsurance is some mystical policy provision that you need to let other people decipher. You have other things to worry about.

First off, it’s not a bad word so relax. Second, it’s an important word so pay attention, please.

If I could, I’d like to add my voice to the many others who have written on this topic and I hope to help you understand it better so that your customers can understand it better.

Why do we have coinsurance?

Contrary to what your friends have told you, coinsurance is not a bad thing. It actually makes sense if you understand how insurance works. Insurance works because a company accepts the risks of an individual or a commercial entity and in return, charges that person a premium, which ends up being a relatively small percentage of the value of the risk accepted.

Think about some insurance policies that you write, or that you buy. If you write a homeowners’ policy with a Coverage A limit of $250,000 and a Coverage E limit of $300,000, the insured isn’t charged $550,000. They end up paying (depending on where they are) somewhere around $2,000 for a policy year. The company is accepting a lot of risk for a relatively small amount of money in return.

It works because the insurer is not just writing one policy. They write thousands of policies, all of them charging a relatively small premium. Premiums are based largely on the limit of insurance purchased, the type of construction, the location, and a few other factors. It can get a little more complicated than that, but that’s the gist of it.

We have coinsurance because some insurance customers are aware that most losses aren’t total losses. Most claims are for partial damage to a building. Since that’s the case, an insured might think that they really only need to purchase insurance for what’s really most likely to be lost. Rather than purchasing a policy based on the total replacement cost of their building, they want to purchase less insurance, based on what they think might be the most likely loss scenario.

That creates some adverse selection, which just means that those who feel more at risk of loss are more likely to buy insurance for that loss. If we allow that to happen, companies have a smaller amount of money available to pay claims. There’s no problem as long as everyone still overestimates their likely risk of loss. The problem occurs when the customers underestimate their likely risk of loss. Then the losses exceed the amount of money available to pay claims. That leads to insolvency. That leads to claims being underpaid. That leads to insureds feeling cheated because they don’t end up getting what they think is due to them.

The purpose of a coinsurance provision is to protect the company and the marketplace from that possibility. It provides a way for the company to motivate the customer to purchase a reasonable amount of insurance for their risks and if the customer still underpurchases their insurance, they become responsible for a share of their loss.

What does the coinsurance provision do?

We have already touched on it, but the simple explanation is that the coinsurance provision requires the customer to purchase a minimum amount of coverage in return for full payment of their claims. As long as the insured building’s limit of insurance meets the coinsurance requirement, the claim will be paid up to the policy limit.

Depending on the specifics of the policy language, if the insured does not purchase enough insurance to meet the coinsurance requirement, the insured may be responsible for a proportion of the claim. What does that mean? It means that in return for purchasing less insurance than they need the insured has the requirement to share in the loss in some way.

For example, if the insured has a building insured on an ISO commercial property policy, the coinsurance percentage is going to be 80, 90, or 100% of the value of the building (depending on the valuation provision in effect at the time of the loss). If the insured building has a replacement cost of $1,000,000 and a coinsurance requirement of 90%, the insured should insure the building for at least $900,000 to have their claim fully paid (up to the policy limit).

On the other hand, if the insured decides that the chances of a total loss are small, she may decide to purchase what she believes is the maximum likely loss, $600,000. If the insurance company allows that, and the same coinsurance provision exists as we just looked at, this limit activates the coinsurance provision. Any loss will be reduced by the ratio of the limit of insurance to the required limit of insurance.

In this case, she bought $600,000 and the coinsurance percentage was 90% on the $1,000,000 building. 90% of $1,000,000 is $900,000. Math alert: $600,000 is divided by $900,000 which equals 2/3 or 66.7%. That means that any claim will be multiplied by 0.667. In short, the insured decided to self-insure 1/3 of the building, which means that she will be responsible for 1/3 of the claim payment (and the deductible).

It’s not a penalty.

You will hear people talk about this provision and call it the coinsurance penalty. I would love for you to show me that in any policy. I don’t read it anywhere. It isn’t a penalty, even though most of us call it that. It’s simply a part of the agreement. It’s like the other insurance clause. In many property policies, if multiple policies can respond to a loss, they will according to their other insurance provision. Each policy will respond.

In the case of an activated coinsurance provision, the insured simply chose to self-insure the proportion between the actual limit and the coinsurance requirement, which means that (like the other insurance provision) the insured is self-insuring that portion of the loss. A penalty indicates the result of violating a rule, law, or a contract provision. The insured didn’t violate any contract provision. He just chose to activate a provision that normally doesn’t need to be activated.

Read the policy, please.

I would be unkind if I didn’t remind you to read the specific policy if your have specific questions about this provision. Policies have other provisions that suspend this provision, other policies may remove it all together. Still others may apply it differently. Read your policy and find out what it says about coinsurance. After you’ve done that, if you have any questions, send us the question and the policy.

Topics Profit Loss