There are some common misconceptions about coinsurance as it applies to commercial property insurance policies vs. medical insurance policies. The differences come down to one word: penalty.
In medical insurance, the coinsurance is how a payment is divided between the insured party and the insurance provider. A figure such as 80/20 would indicate that the insurance provider would pay 80% of a covered medical claim and the insured would pick up the remaining 20% of the same claim.
The word “coinsurance” means something different in property insurance terms. Coinsurance would better be described there as a “coinsurance clause” or more accurately a “coinsurance penalty.” Failure on the part of the insured to comply with the coinsurance requirements of the policy results in a coinsurance penalty in the event of a claim.
What Is Coinsurance?
A coinsurance clause in a property policy is a device to ensure that property is not being underinsured. Typically the quote and declarations will indicate a coinsurance percentage of anywhere from 50% to 100%. Normally a policy will indicate at least 80% coinsurance.
Coinsurance Can Protect You
The rate per square foot for property insurance coverage is determined by several factors: location, age, construction type, size and safety features. This rate is then multiplied by the amount of coverage required for the building to calculate a premium for property coverage.
To save money on your insurance premium, you may be tempted to declare a lower amount of insurance coverage for your building. However, the lower limit of insurance can be detrimental in the event of a loss, since the policy will only pay out the maximum limit in the declaration of the policy in a total loss.
This coinsurance percentage does affect how much the insurance policy will pay out in the event of a loss, but not in the way you might think. The percentage indicated is part of a larger formula used to determine the payout at the time of a loss.
How Coinsurance Works
Most people think that coinsurance for property insurance works the same way that it does in medical insurance, but this is not the case. Property policy coinsurance is calculated as a penalty at the time of loss and affects your payout.
To determine your coinsurance penalty, you take the amount of insurance you purchased and divide that by the amount of insurance you should have purchased (which is the total building value times the coinsurance percentage). The formula for coinsurance penalty calculation looks like this:
For example, you have a $1,000,000 building (home or office) with 80% coinsurance. Per the policy terms, you must insure the building for at least $800,000 (80% of $1,000,000). To save money on your premium you choose to insure for the amount left on the bank loan, $600,000.
This is how your coinsurance penalty would be calculated:
The amount you insured for ($600,000) divided by the amount you should have insured for ($800,000) = 0.75 or 75%. This means that in the event of a partial loss the insurance company will only pay 75% of your claim. In the event of a total loss, the insurance company will pay only the maximum amount listed in the declarations ($600,000).
When Coinsurance Applies
Coinsurance is applied in the event of a partial loss. Because it is a penalty, this means that in the event of a partial loss, only a percentage of the loss will be paid due to underinsuring. Let’s look at that example again:
Did / Should = Penalty
$600,000 / $800,000 = 75%
There is a fire in the kitchen area of your building, and the total damage is $27,000. Because you underinsured the coinsurance penalty applies. $27,000 x 75% = $20,250 (less your deductible!). This leaves you with a $6,750 shortfall to repair the kitchen, money that comes out of your own pocket.
If the entire building burns down the penalty is even greater: the insurance company only pays out the policy limit of $600,000. This is $400,000 less than what you would need to replace the building, and it also comes out of your own pocket.
How to Protect Yourself From a Coinsurance Penalty
The best way to protect yourself from a coinsurance penalty is to properly insure your building for a total loss. Remember, replacement cost insurance valuation may be different than market value. Hayes Insurance has tools to determine replacement cost value. Contact your Hayes Broker to find out more about how to properly insure your building.