Property Insurance: Coinsurance | Expert Commentary

~Song written by Bennie Benjamin, Gloria Caldwell, and Sol Marcus, first recorded in 1964 by

~Song written by Bennie Benjamin, Gloria Caldwell, and
Sol Marcus, first recorded in 1964 by singer/pianist Nina Simone

Let’s play Coinsurance Quiz. Answer true or false to the following
statements.1

  • Coinsurance is a condition that may be found in more than one type of
    insurance policy.
  • The need for a coinsurance provision in all insurance policies is the
    same.
  • The use of a coinsurance provision in an insurance policy is universally
    understood.

The answers are true, false, and false. How did you do?

Coinsurance clauses are found in many insurance policies, such as commercial
property, dwelling forms, homeowners, federal flood, health insurance, and at
times even directors and officers liability policies. But, while the clause or
requirement is called “coinsurance” in each type of policy, the use
and effect on the insured may be very different. The coinsurance requirement in
a property insurance policy may become a significant reason for insurance
recovery that is less than the insured expected. This is why a risk management
professional should hear the melody of “Don’t Let Me Be
Misunderstood
” whenever the term “coinsurance” is discussed
in any insurance policy, especially any form of property insurance.

Coinsurance Concept

Coinsurance requirements differ by insurance policy type to reflect the
insurer’s and/or insured’s specific need. In health insurance, it may
be used as a means of risk sharing between insured and insurer as a means to
lower the insured’s monthly premium cost. For example, covered expenses
above the deductible may be shared 80 percent insurer/20 percent insured until
a policy-stated total is reached. If the total was $2,500, then the insurer
would assume $2,000 (80 percent of $2,500), while the insured’s portion
would be $500 (20 percent of $2,500). This arrangement is sometimes referred to
as a “corridor deductible.”

In a directors and officers liability policy, the insurer may use it as a
risk sharing technique to get “skin in the game” from the insured
organization and/or director and/or officer. It may be used to reduce the
annual cost of the policy, an arrangement that is similar to that used in
health insurance.

Coinsurance in property insurance is a means for insurers to obtain rate and
premium equality. Property insurers must have a standard in which to apply
expected losses based on past loss experience over an entire underwriting book.
This is accomplished by getting the exposure base (total insured value for
building, contents, and business income) on a common basis for all property
insurance insureds: replacement cost, actual cash value, and actual loss
sustained. Rates are applied against a specified percentage (100, 90, or 80
percent, for example) of the value to the insured: building, contents, or
business income. Rate deviations are applied against the base (manual) rate to
reflect size of deductible, construction, occupancy, and loss control
standards.

A “coinsurance” condition in a property insurance policy is
analogous to the need for a standard definition of “payroll” to
compute workers compensation premium. All workers compensation insurers use the
same “payroll” definition established by workers compensation rating
bureaus such as the National Council on Compensation Insurance. This way, all
workers compensation insureds report their insurable exposure (payroll) on the
same basis. This allows an insurer to start its premium rating basis on an
equal basis for all of its insureds—expected losses can be applied to develop a
payroll rate. Rate deviations are then applied to reflect deductible (if any),
premium discount, and other factors, including adequacy of loss control (rate
credit or debit).

How It Works

Property coinsurance clauses may differ by insurer, especially if using an
independently filed policy form, although coverage intent may be the same. The
examples used in this article are based on current Insurance Services Office,
Inc. (ISO), policy forms. The reader is cautioned to read the property
insurance policy to ensure that the coinsurance clause is the same as that
expected and understood by the insured and the
broker/agent.

Direct Damage: Commercial Insurance

First, the insured must set the direct damage coverage limit, which is based
on how loss is to be settled: replacement cost or actual cash value
(replacement cost less depreciation equals actual cash value). Next, the
coinsurance percentage for building and contents must be determined since
coinsurance requirements start at 100 percent and provide the greatest rate
credit at this percentage of limit to value, but the insurer may allow the
insured to go as low as 80 percent. The best way to establish insurable value
is by use of a recent appraisal of the building and/or contents or by use of a
prior appraisal that can be brought current (trended) through inflation factors
provided by the appraiser or the insurer. A “guestimate” process may
not provide the accuracy needed to establish credible value and the insured
limit, which may result in a coinsurance penalty, as will be explained
later.

To settle a loss, the insurer will compare the policy limit (depending on
the actual policy, it may be a location-specific limit for building or
contents) to the minimum limit required by the coinsurance clause. The formula
is fairly simple.

Figure 1: Loss Recovery Formula

Loss Recovery Formula

Example: Direct Damage

An insured owns a 25,000 square foot building that is 10 years old. He asks
the builder to give him an estimate of what it would cost in 2012 to build the
same structure from the ground up. He is told $80/square foot for total
estimated replacement cost of $2 million. He decides to insure the building to
90 percent of its estimated replacement cost value.

Scenario 1. A few months into the policy year, the building
suffers a substantial fire loss, and the insured files a claim for $800,000.
What is the insurance recovery after a $5,000 deductible?

Figure 2: Direct Damage Scenario 1

The replacement value of the building as determined by
independent appraisal
$2,100,000
Coinsurance requirement 90%
Minimum coinsurance limit $1,890,000
Insured limit $2,000,000
Limit satisfies coinsurance minimum limit
($2,000,000/$2,100,000)
Yes
Reported loss $800,000
Less coinsurance penalty $0
Less deductible ($5,000)
Net insurance recovery $795,000

Scenario 2. The insured decided at each renewal since 2012
that his building can remain insured for $2 million. The loss settlement clause
remains replacement cost. The insured does not seek any independent counsel on
the building’s estimated replacement cost in 2016. The building is damaged
by fire in mid-2016, and repairs total $500,000. The replacement cost of the
building is determined to be $2.4 million. What is the insurance recovery after
a $5,000 deductible?

Figure 3: Direct Damage Scenario 2

The replacement value of the building as determined by
independent appraisal
$2,400,000
Coinsurance requirement 90%
The coinsurance limit (insured value to insured limit $2,160,000
Insured limit $2,000,000
Limit satisfies coinsurance minimum limit No
Reported loss $500,000
Less coinsurance penalty
($2,000,000/$2,160,000)
.926
Gross loss subject to insurance
recovery
$463,000
Less deductible ($5,000)
Net insurance recovery $458,000

Scenario 3. The insured decided at each renewal since 2012
that his building can remain insured for $2 million. The loss settlement clause
remains replacement cost. The insured does not seek any independent counsel on
the building’s estimated replacement cost in 2016. The building has a fire
in mid-2016, and the building is a total loss. The replacement cost of the
building is determined to be $2.4 million. What is the insurance recovery after
a $5,000 deductible?

Figure 4: Direct Damage Scenario 3

The replacement value of the building as determined by
independent appraisal
$2,400,000
Coinsurance requirement 90%
The coinsurance limit (insured value to insured limit $2,160,000
Insured limit $2,000,000
Limit satisfies coinsurance minimum limit No
Reported loss $2,400,000
Less coinsurance penalty
($2,000,000/$2,160,000)
.926
Gross loss subject to insurance
recovery*
$2,000,000
Less deductible ($5,000)
Net insurance recovery $1,995,000

Business Income: Commercial Insurance

The process to establish the coinsurance minimum limit for business income
is more complicated than that used for building and contents direct damage. The
reason is that the insured must determine net income and operating expense
expected for the policy year and then deduct operating expenses that would not
be expected to continue during the period of interruption (prepaid freight for
outgoing shipments, cost of materials that would otherwise be consumed during
the manufacturing process, power that is not consumed, ordinary payroll if it
is not to be continued, etc.).

Extra expense coverage is not subject to a coinsurance clause. An insured
can ask an insurer to quote any limit that is deemed appropriate. Extra expense
coverage when offered as coverage separate from business income may contain
certain percentages such as 40/80/100 percent. These percentages are not
coinsurance but a means to limit the payout of the coverage: up to 40 percent
for the first month of recovery; up to 80 percent for the next month of
recovery; and no more than 100 percent for the final month of recovery. It is
important for the risk management professional to review any percentage used in
extra expense coverage to ensure that the coverage provided meets the extra
expense needs of the insured.

Example: Business Income

A manufacturer completed a business income work sheet for the recent policy
period based on operating 240 days per year (after plant summer shutdown and
usual employee paid holidays). The annual business income value is $8 million
with an 80 percent coinsurance clause. The insured limit is $6.4 million,
excludes ordinary payroll, and is subject to a one daily average value (ADV)
deductible.

Scenario 1. A fire occurs and damages key equipment, and
the plant must shut down for 3 months. A business income claim of $2.7 million
is filed with the property insurer. What is the net insurance recovery after
the deductible?

Figure 5: Business Income Scenario 1

Actual net income and operating expense for 12 months $7,900,000
Coinsurance requirement 80%
The coinsurance limit $6,320,000
Insured limit $6,400,000
Limit satisfies coinsurance minimum limit Yes
Reported loss $2,700,000
Less coinsurance penalty None
Gross loss subject to insurance
recovery
$2,700,000
Less deductible: 1 ADV ($7,900,000/240)* ($32,917)
Net insurance recovery $2,667,083

Scenario 2. Three months after renewal, the company lands
three large contracts, and net income surges to an additional $3 million in the
past 5 months. A fire occurs and damages key equipment, and the plant must shut
down for 3 months. A business income claim of $2.7 million is filed with the
property insurer. What is the net insurance recovery after the deductible?

Figure 6: Business Income Scenario 2

Actual net income and operating expense for 12 months $10,900,000
Coinsurance requirement 80%
The coinsurance limit $8,720,000
Insured limit $6,400,000
Limit satisfies coinsurance minimum limit No
Reported loss $2,700,000
Less coinsurance penalty
($6,400,000/$8,720,000)
.734
Gross loss subject to insurance
recovery*
$1,981,800
Less deductible: 1 ADV ($10,900,000/240)* ($45,417)
Net insurance recovery $1,936,383

Coinsurance issues can occur quickly if an organization experiences net
profit growth that had not been expected at the time the business income work
sheet was completed. This is what happened in Scenario 2. The risk management
professional should compare actual net income to that forecast for the policy
year on a regular basis.

Commercial Insurance Coinsurance Tools

A property insurer may waive the coinsurance requirements of the policy if
requested by the insured and if the insurer believes the limit to be purchased
is sufficient. This is often done by use of an agreed amount endorsement where
the insurer will waive coinsurance for the policy coverage period. Sometimes
insurers will provide an inflation guard endorsement to the policy in which the
building and/or contents limit is increased a certain percentage at each
renewal. Educating an insured on how coinsurance works may result in better
selection of insured limits and lessen the potential for an errors and
omissions claim again the agent or broker.

Homeowners Insurance (HO 2 and HO 3)

Some insureds may be surprised to learn that a homeowners policy, especially
if based on ISO policy forms, has a coinsurance clause that can impact
coverage. In ISO forms, if the limit of insurance on the damaged home is 80
percent or more of the full replacement cost, then replacement cost valuation
will be used, subject to the lesser of policy limit or repair or replacement
cost. If the insured home fails the 80 percent coinsurance requirement, then
loss is settled on actual cash value.

National Flood Insurance Program (NFIP)

The NFIP Dwelling Form (ed. 5/08) provides replacement cost valuation if the
dwelling is the insured’s principal residence and either the amount of
insurance is at least 80 percent of the actual replacement cost value prior to
loss or the coverage limit is the maximum amount available from the NFIP.

Conclusion

The concept and use of coinsurance in property insurance should not be
difficult to understand if the risk management professional takes time to read
a property insurance policy. The ISO commercial property and business income
forms include actual examples of how coinsurance applies when the insurance is
adequate and not adequate. The risk management professional needs to understand
and point out to insureds that even an HO form and NFIP dwelling form have
coinsurance requirements that can affect coverage. To paraphrase the song
performed by Ms. Simone, “… coinsurance don’t be
misunderstood.”


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