Author: Bill Wilson

One of the toughest tasks facing insurance agents involves how to go about explaining coinsurance...why it exists, what's its purpose, and how it works. Below is an explanation that you might find of value in discussing the purpose of coinsurance with your clients, along with a deposition excerpt from an agent who couldn't explain it.

Before we get started, take a look below at an excerpt from an E&O case involving an agent who was asked (actually, he VOLUNTEERED...ouch!) to explain coinsurance. His inability to do so effectively resulted in the E&O carrier settling with the plaintiff out of court.

Although most commercial property policies provide examples of how coinsurance works (e.g., check out the Additional Conditions - Coinsurance in the CP 00 10 06 07), why policies have such a clause is a mystery to most insureds...and many agents. So, let's look at the purpose behind coinsurance...

The coinsurance condition was introduced as a standard clause by the Louisville Board of Fire Underwriters in 1885 for pork and tobacco risks and was expanded to other property in 1890. However, individual insurer use of this condition dates back to at least 1877 (Continental Insurance Company), if not earlier.

Coinsurance is a contractual requirement that the insured carry agreed upon insurance-to-value, as specified by a percentage (usually 80%, 90% or 100%) entry on the Declarations page. If, at the time of loss, the limit of insurance is less than the value of the property times the coinsurance percentage, the insured will become a "co-insurer," along with the insurance company, when a loss occurs.

The purpose of coinsurance is not to punish an insured for carrying inadequate insurance-to-value, but rather to provide a financial incentive that: (1) encourages them to carry adequate limits in the event of major losses, and (2) rewards them (in many instances) with a significant premium reduction for doing so.

Why do insureds need an incentive to carry limits of insurance approaching the value of their property? Simple...because, in the aggregate, most losses are partial and don't result in a total, or even substantial, loss. Without a financial incentive, insureds who are not risk aversive might be inclined to purchase relative small limits of insurance. Since that inclination depends, in part, on the structure and occupancy of the building, the amount of the incentive is largely determined by those factors.

To illustrate, according to one estimate, less than 2% of fire losses are total, and 86% of fire losses result in damages of 20% or less of the building value. That is, if a building is worth $500,000 and a fire occurs (which isn't that likely to begin with), there is an 86% chance that the damage will be $100,000 or less. So, if the insured is a risk taker, why not insure the building for $100,000 or less? Of course, the statistics above are just for the peril of fire...if you add windstorm and other potentially catastrophic perils, the numbers may change.

These numbers are averages. Statistically, a reinforced concrete office building is MUCH less likely to experience a major loss than a wood frame woodworking shop. So, the owner of the office building could be less inclined to carry full insurance to value because the probability of a serious loss is virtually nil. On the other hand, the owner of the woodworking shop is much more likely to insure to value because it is easy to conceive of a major loss occurring.

Coinsurance provides an incentive for adequate insurance-to-value by providing a rate credit for carrying relatively high limits to value...the credit is much larger for the fire-resistive office building because the owner needs a larger incentive and the rate credit reflects the lower probability of loss. For example, look at the calculations below:

The gross rates and premiums are the rates and premiums that would be charged if coverage was written without a coinsurance requirement. The 80% rates and premiums are those that apply when the insured contractually agrees to carry a limit of at least 80% of the value of the property at the time of loss. Note that the woodworker gets only a 10% credit from the gross (no coinsurance) premium, while the office building gets a 70% credit.

What if the owner of the fire-resistive building heard that there was only a 14% chance that a fire loss would cause damages in excess of 20% of the value of the building...wouldn't he/she only buy $20,000 of insurance? No, because he/she couldn't pass up the bargain, as shown below (and we all know that most insurers wouldn't let him anyway :-):

As you can see, if the insured elected to buy only $20,000 coverage rather than $80,000, he/she would experience a premium reduction of less than 17% while reducing the coverage amount by 75%. Conversely, for 25% in additional premium, the insured can increase his/her coverage by 300%!

Thus, coinsurance provides an incentive to purchase higher insurance to value than some (perhaps many) insureds would be inclined to do otherwise. In doing so, insureds can save significant amounts and they have the assurance that, in the unlikely event that they do have a major loss, they're covered.

For more on this topic, check out the following articles:

• Coinsurance101

• Coinsurance and Valuation - Part 1

• Coinsurance and Valuation - Part 2

• Coinsurance Visualizer