Coinsurance does not interfere with full payment for a loss as long as the insured complies with the promise to carry limits equal to the percentage agreed upon. Technically, the coinsurance clause can be removed from a policy, but the penalties built into rating plans for doing so make such an option impractical in most cases.

This article offers a thorough and practical guide to coinsurance. It summarizes what coinsurance is, how it works, and how courts view coinsurance.

Topics covered:

Why coinsurance?

How coinsurance works

When the deductible applies

Coinsurance affirmed by courts

Establishing a value for coinsurance

Buildings and personal property

Why Coinsurance?

 Many agents have difficulty explaining coinsurance to their customers. A good method of explanation is to ask the customer to think of insurance as a big pot. Into that big pot is where the many customers of an insurance company put their premiums. It is out of that same pot that the few with losses take money to cover those losses. The principle of coinsurance says that an insurance company needs to collect premiums on total values at risk (either actual cash value or replacement cost) equal to at least 80 percent of the total value to which the insurer is exposed. If that amount of money goes into that big pot, then there will be enough money in that pot to pay the full value on partial losses.

 Coinsurance is also beneficial in that the coinsurance requirement establishes a basic fairness in premium rates—especially in the case of partial losses, which are overwhelmingly the most likely to occur.

 For example, consider identical warehouses, both valued at $250,000 and insured under commercial property policies. Neither policy contains a coinsurance requirement. Each policy is priced at a rate of $1 per $100 of coverage. Warehouse owner A insures his property for $200,000; warehouse owner B insures his for $50,000. Thus, A pays a premium of $2,000 and B a premium of $500.

 One day a tornado strikes the town. Both warehouses suffer $40,000 in damage. Since neither policy contains a coinsurance requirement, both warehouse owners will be paid in full for their loss, even though A paid 4 times as much premium as B.

 B can afford to consider buying only $50,000 of insurance because most property losses are small in relation to the total value of the property insured. One study found that 75 percent of insured property losses were 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 business person can insure his 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.

 Whereas many sophisticated business persons might choose to play the odds and insure their property at 50 percent of value to save substantially on premiums, others want the comfort of knowing that 100 percent of their property is covered. If a majority of insureds chose limits at 50 percent of value, the premiums paid to insurance companies would be drastically reduced, while their losses would not be materially reduced because 95.5 percent of property losses are 50 percent or less of the property's total value.

 By insisting on a coinsurance clause, insurers can charge lower rates per $100 of coverage for all insureds, because all buyers must purchase more insurance. For example, assume that all the fire losses in a territory equaled $1 million annually. The insurance industry knows it must collect $1 million plus enough to offset expenses and earn a profit, totaling, for instance, $1.3 million. Let's say that the total value of property in a territory is $1 billion. If the property insureds in that territory purchase a total of 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.

 However, by requiring the purchase of insurance equaling 80 percent of the at-risk total (or $800 million of coverage), then the insurer would need to charge a rate of 16.5 cents per $100 in order to generate the $1.3 million it needs to operate ($.165 times $800 million divided by 100). In this way, all insureds can afford more adequate and more equitable coverage. For the same premium, an insured can 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.

 Insureds who do not include a coinsurance clause in their insurance contracts are surcharged to raise their rates to a level that would generate the premium needed for the insurance industry to cover its losses, expenses, and profit.

 How Coinsurance Works

 With the coinsurance clause, the insured agrees to maintain a specific relationship between the amount of insurance carried and the value of the property insured. If the insured does not comply with that agreement, he or she becomes a partner (a coinsurer) with the insurance company; that is, the insured assumes a portion of the cost of each loss according to a formula set out in the insurance policy. If the customer maintains insurance at the specified percentage, most often 80 percent of the value of the property, the insurance company will pay the full amount of any covered loss up to the policy limit, less the deductible, of course.

 For example, a person who insures property with an actual cash value of $100,000 on a policy with an 80 percent coinsurance requirement is required to purchase $80,000 of coverage (80 percent of $100,000). If the insured elects to carry only $60,000 (60 percent of the actual cash value), then he becomes a partner with the insurance company on partial losses.

 The extent of the insured's participation—also known as the coinsurance penalty—is calculated as follows. The amount recovered (A.R.) from the insurance company on partial loss equals the amount of insurance carried (I.C.) divided by the amount of insurance required (I.R.) by the coinsurance clause times the loss (L.).