Coinsurance Clause

Insured regularly disagree with the amount of insurance they are required to purchase for a piece of property. If you own your property outright, you can buy as little or as much coverage as you want. But it doesn’t make sense to buy coverage that’s above the actual value of your property. Property insurance policies are designed to restore you to where you were before the loss, not to help you make money off your covered loss. If your property is leased, rented, or financed, you have another interested party that has to be satisfied in the event of a loss.

Of course, the lower the coverage amounts, the lower the overall insurance premium, which is what we are searching for, right? This is how some get in trouble for buying too little coverage. This is also where the coinsurance requirement comes in. Mortgage lenders might request a replacement cost estimate to verify that your coverage A covers the right amount. Auto insurance companies automatically calculate these numbers and price your collision and comprehensive rates based on your car’s VIN combined with your driving record and other factors. Auto lenders then require collision and comprehensive coverage with a reasonable deductible until your car is paid off.

Insurance policies may also contain a coinsurance clause in order to attempt to sway an insured to maintain adequate coverage throughout the policy term.

Let’s first take a look at what coinsurance is and does, then look at the consequences of not adhering to the coinsurance clause in your policy, which is the coinsurance penalty.

What is coinsurance?

Coinsurance, also known as a “coinsurance clause” in an insurance policy, is a requirement (policy condition) that states an insured must carry insurance equal to at least a certain percentage of a property’s actual cash value (ACV).

This is done to ensure a piece of property is not underinsured when the replacement cost loss settlement option is purchased.

The necessary coinsurance percentage will vary by insurer and type of coverage. For homes, it’s typically based on current construction costs, the style and type of construction, and the square feet in your home.

Many homeowners insurance companies will calculate their own replacement cost value and only issue a policy if that amount of coverage is purchased. This number is typically less than the purchase price of the home. So mortgage lenders will ask for a replacement cost estimate from your insurance company. This eliminates the concern of not having enough purchased enough coverage.

In terms we can all understand; the insurer does not want to be in a position to pay to rebuild a piece of property at full replacement cost when the property was only insured for a fraction of its actual cash value. A mortgage lender does not want to have a property they have money invested in destroyed with a borrower who cannot pay to rebuild it.

An extreme example depicting the situation described above would be insuring a building for $100,000 when the ACV was $200,000.

An uneducated or unscrupulous insured may attempt to obtain the lower coverage amount to reduce their overall premium, but still expect the property to be rebuilt (if replacement cost coverage was obtained) at a cost of $220,000.

Of course, the insurance company bases their premiums on having detailed and accurate property information. If you have a custom home and get it insured as an economy construction style, you would not get an accurate replacement cost estimate. You might also be in for a rude awakening in the event of a major claim.

Insurance companies could not stay in business if they were charging too little for insurance and paying out insurance claims for twice the amount of coverage originally purchased.

What is a coinsurance penalty?

You will incur a “coinsurance penalty” in the event you suffer a property loss and it is determined you do not have the required coverage.

The coinsurance penalty is designed to reduce the amount of a loss payment by the percentage the covered property was underinsured.

Specifically, the coinsurance penalty can be described as the amount of insurance you carry, divided by the amount of insurance you should have carried, multiplied by the amount of your loss, minus any applicable deductibles.

A simpler way to remember the formula is; “did carry over should carry, times loss, minus deductible.”

Let’s look at an example of how a loss would be paid if the coinsurance clause wasn’t met (penalty):

Actual Cash Value of your building at the time of loss: $100,000
Required Coinsurance: 80%, or $80,000 (100,000 x .80 = 80,000)
Amount of Coverage You Carried at time of loss: $60,000
Amount of Loss (perhaps a fire in your home): $30,000
Your deductible: $1,000

Here’s the math:

$60,000 (did carry) – divided by $80,000 (should carry) = ¾ or 75%
75% Multiplied by $30,000 (amount of loss) = $22,500
$22,500 Minus $1,000 (deductible) = $21,500

Your loss payment from the insurer would be $21,500, not the $29,000 you would receive if your coinsurance clause was met (don’t forget the deductible is applied regardless of the coinsurance clause). The important thing to understand is even if you don’t suffer a total loss, if you only had 50% of the coverage you should have, you would only get 50% of the total payout for your loss minus deductibles.

This example demonstrates the importance of insuring your property up to at least the coinsurance clause amount on your policy.

The penalties can greatly increase as property values go up since we are dealing with percentages rather than flat rates.

Can you get insurance over coinsurance requirements?

What if you want to be extra careful and buy extra insurance? If you’re looking at auto insurance, some companies have what they call newer car replacement cost. Typically, this covers a car that’s one year newer with less miles. If you’re buying homeowners costs, there are supplements you can buy to cover surge pricing in the event of a major catastrophe (like a hurricane) or inflation. Keep in mind, this doesn’t override the traditional limit of insurance. Even though you pay more for these supplements, they still only go far enough to make you whole again. They do not serve to make you money in any way.

Contact your insurance agent or insurer if you are not aware of what your coinsurance clause is or just to make sure you are meeting the requirement.