Coinsurance ... one of the most confusing and misunderstood terms in the world of insurance.
And one of the major contributing factors to that confusion is found buried in the very definitions.
Yes, 'definitions' is plural because coinsurance has so many uses in the insurance industry. So to define coinsurance, for example in the health insurance world is drastically different, and many would argue easier to understand, than coinsurance in the property & casualty insurance market.
To further complicate matters, a coinsurance clause or requirement can appear in many different types of insurance policies, including homeowners, commercial property, business income, and more. BUT, the use and impact of coinsurance can vary widely within each type of policy.
So what are consumers to do?
Sure, taking the time to understand your insurance policies is important and well worth the effort, but honestly, when's the last time you actually dusted off that monster document known as your insurance policy and read it cover to cover?
After all, insurance policies are complex legal documents, often containing provisions that assign certain responsibilities to the policyholder (that would be you). And it just so happens the coinsurance clause is one of those (meaning your) responsibilities.
But not to worry, we're here to help you navigate this incredibly complex requirement, so if you're ready, let's dive in.
What is coinsurance?
You may be more familiar with coinsurance when it’s used in health insurance terms. It’s used as a means of risk sharing between insured and insurer in order to lower the insured's monthly premium cost.
So, if you have an 20% coinsurance clause in your health insurance plan, the company pays 80% of the bill and you (the insured) pay the remaining 20%. A $1,000 doctor’s bill would be paid at 80%, or $800 and you pay the remaining $200. This information is all pretty straight-forward, right?
If we were strictly concerned about health insurance and the application of coinsurance, our lives would be much easier.
But unfortunately, we have more work to do because the coinsurance that's likely to get you into far more of a hairy situation is found in policies like homeowners insurance, commercial property and business income.
Nearly all property insurance policies include a coinsurance clause. Building, business personal property and even homeowner policies all contain a coinsurance clause. And unfortunately, in the property and casualty world, coinsurance has an altogether different meaning.
Let’s start with the technical explanation…according to the International Risk Management Institute, coinsurance is:
"A property insurance provision that penalizes the insured's loss recovery if the limit of insurance purchased by the insured is not at least equal to a specified percentage (commonly 80 percent) of the value of the insured property. The coinsurance provision specifies that the insured will recover no more than the following: the amount of the loss multiplied by the ratio of the amount of insurance purchased (the limit of insurance) to the amount of insurance required (the value of the property on the date of loss multiplied by the coinsurance percentage), less the deductible."
Let us try to simplify it for you – the coinsurance section of your policy gives your insurance company the right to penalize you by reducing the amount of your claim payment in the event that the amount of insurance you purchased is inadequate.
So, if you look at your policy declarations page and it has a percentage (i.e. 80%, 90% or 100%) listed next to the limits for your building, personal property or business interruption, than your property insurance policy contains a coinsurance clause. This clause means that you have made a promise to the insurance company that the limit of coverage that you selected is at least equal to that percentage of the actual replacement value of what you are insuring.
In most policies, the standard amount of insurance that must be purchased is equal to 80% of the replacement value of the property, but it can be as high as 100%.
Although some policyholders think that 100% is better than 80%, the reverse is actually true.When you select 100% coinsurance, you have no leeway. You've essentially promised your insurance company that the replacement value you selected is 100% accurate.
For this reason, it's vital for values of property to be accurately reported and updated annually to reflect inflation and other increases in cost.
Calculating coinsurance & avoid a costly penalty
In the simplest terms, the coinsurance provision in a property policy requires the policyholder to carry a limit of insurance equal to a specified percentage of the value of the property in order to receive full payment at the time of a loss (I know, that's confusing, but we'll get to a real-life example in a second and that might help).
In property insurance, coinsurance will never result in a larger payment on a claim. It can only reduce the settlement, or in the best-case scenario, it'll have no impact at all on the claim settlement amount.
Here's an example: we'll use the following assumptions for illustration purposes
- Your building has a value of $1,000,000
- The policy you have covering this building has an 80% coinsurance clause
- Based on the assumptions, your building must be insured for at least $800,000 to avoid a coinsurance penalty at time of loss
Here’s where it gets a bit more complicated
If there's a claim, the formula (Value of the property x Coinsurance percentage = Minimum insurance amount required) to determine the recovery is based on the property’s replacement value at the time of loss.
If the replacement amount is less than the coinsurance percentage, a penalty is applied, reducing the claim payment.
Back to our example, let's further assume that instead of insuring your building for $800,000, instead, you decided $600,000 would be adequate coverage. Now you have a fire that causes $200,000 in damages.
You have $600,000 of coverage and a $200,000 claim, so you're good... right?
Unfortunately, not so.
The claim is calculated by dividing the amount of insurance purchased ($600,000) by the amount that should have been purchased based on the coinsurance percentage selected ($800,000). This factor (75 percent) is multiplied by the amount of the loss ($200,000 x .75 = $150,000). In this example, the policyholder would receive $150,000 (less any deductible) for a $200,000 claim.
Additional examples of coinsurance in action:
Scenario 1: Coinsurance requirement IS NOT satisfied
Facts at the time of the loss:
- Total limit of insurance = $51,100
- Coinsurance amount = 80%
- Deductible amount = $1,000
- $20,000 claim to replace the roof and siding due to hail damage
We'll go through each of the steps to determine the final claim settlement amount.
- According to the insurance contract, the insurance company will first determine the replacement value of the property at the time the loss occurred. In this example, the property had a value of $149,000.
- The next step is to multiply the value of the property (determined in step 1) by the coinsurance percentage listed in the policy: $149,000 x 80% = $119,200.
- Now we need to divide the limit of insurance shown in the policy ($51,100) by the figure determined in step 2: $51,100 ÷ $119,200 = 42.9%.
- Multiply the total amount of the claim by the percentage determined in step 3: $20,000 x 42.9% = $8,580.
- Subtract the deductible amount from the amount determined in step 4: $8,580 - $1,000 = $7,580.
When policy coverage amounts do not meet the coinsurance requirement, claim payments can be drastically reduced depending on how severely underinsured the property is at the time of the loss.
In the example above, what appeared to be a straightforward $20,000 loss for which the insured should have been reimbursed $19,000 ($20,000 less the $1,000 deductible), instead was reimbursed only $7,580.
The difference, $11,420, represents the penalty amount incurred for carrying limits of coverage that are inadequate and do not represent the actual replacement cost.
Scenario 2: Coinsurance requirement IS satisfied
Facts at the time of the loss:
- Total limit of insurance = $290,000
- Coinsurance amount = 90%
- Deductible amount = $1,000
- $20,000 claim to replace and repair the damage
- According to the insurance contract, the insurance company will first determine the replacement value of the property at the time the loss occurred. In this example, the property had a value of $300,000.
- The next step is to multiply the value of the property (determined in step 1) by the coinsurance percentage listed in the policy: $300,000 x 90% = $270,000.
At this point, we can see that the amount of coverage in place ($290,000) exceeds the minimum amount required ($270,000) and therefore, the coinsurance requirement as been met. In this example, the coinsurance provision of the policy will have no impact on the final claim settlement amount - again, the best case scenario when addressing the coinsurance provision.
Because the building limit meets the minimum amount of insurance required under the coinsurance clause, the amount due on a claim is not affected. The amount payable based on replacement cost is $19,000 ($20,000 claim less the $1,000 deductible).
Why do policies have the coinsurance provision?
Believe it or not, this provision does not exist just to punish the insured, or get the insurance company out of paying the full value of a claim.
While it may seem like coinsurance is used to make the insured responsible for a portion of a loss, it’s really used to encourage the insured to carry an appropriate amount of insurance in relation to the value of the their property, especially on replacement cost policies.
If insured’s look to save premium dollars by insuring for less than the specified coinsurance percentage of their property, they effectively become coinsurers for any loss.
Insurance rates are determined on a number of assumptions. A major one is projected losses. Another is that every insured will select enough insurance, dollar-wise, to cover the full value of an insured property.
However, some insureds will figure that most losses are small and rarely a total loss - statistics would prove this to be true. So those insureds will insure for less than the value of the property. In turn, the premiums received by the insurance company are less than expected.
Problem is, when the major, or even total loss does occur, adequate premiums have not been collected to fully reimburse for the amount of the claim.
So it's not so much that the insurance company is requiring insureds to insure to a certain value, they're just making provisions to properly distinguish between those who do insure to the full value vs. those who insure at a lower amount.
The insurance company reasons that if you want to insure for less than full value, you'll have to share in the losses. The insurance policy will set a coinsurance percentage, frequently 80%. That percentage will be the basis for loss sharing. If the insured maintains insurance to the required percent, there is no loss sharing.
On a broader scale, coinsurance is critical because statistics show that if less than 80% of the replacement value is covered, insurance companies would not collect enough premium to pay all the claims that clients are due when a disaster strikes.
Think of it this way, you go out to dinner with a large group of friends, but there is only one bill for the entire group. Everyone agrees to contribute their fair share to cover the charges. If only some people contribute their share of the bill, there won’t be enough money to pay for the dinner. Insurance operates the same way.
Insurance companies estimate what their claims and expenses will be in the short-term and using this information, calculate the amount insured’s need to pay to cover the claims and expenses necessary to keep the insurance company in business. If some of the insured’s don’t buy a sufficient amount of coverage, the necessary amount of money to cover all claims that might arise won’t be there when the time comes.
What’s the solution?
Don’t ever insure your property at an amount below the coinsurance requirement. In fact, for the minimal additional premium, there’s no reason property shouldn’t be insured at its full replacement value.
Too often, agents try to cut the cost of the policy by reducing the coverage offered. It might not seem like a big deal and chances are, you would probably be comfortable with the limit of coverage being recommended. However, the small details could severely impact your coverage in the event of a claim.
You can also suspend the coinsurance clause for the term of the policy by adding an agreed value endorsement. This is a provision where the insurer and the insured agree that the amount of insurance is adequate and the coinsurance clause will not apply to a loss.
Other avoidance tools are Replacement Cost Coverage and Inflation Guard Protection. These prevent your coverage from falling below the required coinsurance percentage, forcing you to share a loss.
Discuss your options with your insurance advisor. The coinsurance details are often found in the “Conditions” section of your policy and may seem rather harmless. But the fine print is critical; if you don’t understand them, ask your advisor to explain them to you.
We're just scratching the surface of the complexities of the insurance world here, but the coinsurance provision is often one of the major pitfalls we discover when working with new clients.
No one wants to overspend for insurance coverage, however, the right insurance protection is still critical to the success of your business, or the ability for your family to recover after a catastrophic loss. Without it, you're one claim away from being out of business or having your personal finances ruined.
And remember, not all policies are created equal.
Look, 1-800 numbers and online quotes are great if you know precisely what you want and need. But, when you dive into the details after a claim occurs, usually you're met with disappointment in terms of what the insurance company is willing to offer you for your claim.
Wouldn't it be easier to get the right policy, at the right price, right now? Rather than buying the cheapest option you can find online or through a 1-800 number, only to discover it's the cheapest for a good reason?
If you said yes, then work with an Insurance Advisor that's looking out for your best interests, and not someone that's just trying to sell you a policy. You're a person, you deserve to be treated that way.
We can help.
We know the industry, we understand your needs, and we work with multiple insurance companies so we can deliver the insurance solution that’s perfect for your business, your family, and your budget.
The bottom line is, when you have confidence in your insurance protection, you have greater peace of mind knowing that you can recover even when disaster strikes.
About the author
Larry Middaugh comes to Hill & Hamilton with an extensive background in sales, bringing over 30 years of experience and commitment to taking care of his clients in the banking and mortgage industry.
Larry's dedication to his clients aligned so well with the H&H tradition of relentlessly caring for, and protecting its clients, that he joined the team of Licensed Insurance Advisors in 2015.