Homewoners Insurance

Coinsurance for Dummies

Homeowners policies no longer contain coinsurance clauses, so you only need to know about this if you have a dwelling fire policy or a commercial fire or package policy. Some say it was invented right here in Louisville, Kentucky in the mid 1880’s.

Coinsurance actually is an incentive to carry insurance to value, not a penalty for failure to do so. Before coinsurance, people regularly bought $2,000 coverage to cover their $20,000 property. They did this for two reasons:

1. They couldn’t afford to insure for the whole $20,000.
2. They knew that chances are they wouldn’t have a total loss anyway, since most losses are partials.

Coinsurance has two parts, sort of like the good news and the bad news. The good news is that there is a premium credit that is applied to the policy. The bad news is that there is a penalty applied for underinsurance.

THE GOOD NEWS EXPLAINED
The credit is commensurate with the exposure. For instance, a wood frame dynamite factory located in a rural area far from a fire department would get very little credit, but an all concrete and metal sprinklered fire resistive office building located near a fire department would receive a hefty premium credit for 80% coinsurance. The reason is obvious. If you owned the dynamite factory above and it was worth $100,000, you would not be inclined to only insure it for $20,000, because we all know if a fire starts, it is going to be a total loss. However, if you own the office building in the example above, assuming it was also worth $100,000, you might be inclined to want to insure it for only $20,000, since we all know the chances of a total loss are pretty slim.

An example of the effects of the coinsurance rate credit is shown in the table below.

BuildingConstructionValueGross Rate80% RateNo Coinsurance Premium80% Coinsurance PremiumOffice BuildingFire Resistive$100,000$.75 per $100$.21 per $100$750$210Dynamite FactoryWood Frame$100,000$4.00 per $100$3.60 per $100$4,000$3,600

As you can see, the Office Building in our example gets a much higher credit for coinsurance than the Dynamite Factory. Again, the reason is because the Dynamite Factory has little chance for a partial loss.

Lets examine the effect that the coinsurance credit can have on premiums.

Office Building Policy LimitNo Coinsurance Fire Rate per $10080% Coinsurance Fire Rate per $100100% Coinsurance Fire Rate per $100Premium$20,000.75$150$80,000.21$168$100,000.19$190

As you can see, if the Office Building insured elects to insure his building for $20,000 without coinsurance (assuming an underwriter would allow this) the premium would be $150, compared to only $168 for $80,000 coverage with an 80% coinsurance clause attached. From the standpoint of where we were before coinsurance, the Office Building owner can now buy 4 times the coverage as before for only a 12% increase in cost or 5 times the previous coverage for only a 26% increase. This is truly good news.

THE BAD NEWS EXPLAINED
As we saw above, coinsurance can be a truly great thing for the Office Building owner in our example above. This premium credit does not come without a price though. The price is the coinsurance penalty or coinsurance clause that is attached to the policy. The clause stipulates that (disregarding any deductibles) the amount the insurance company will pay for the claim is equal to the equation below:

Insurance Amount Actually CarriedLoss Payment =-------------------------------------------------------------------------------X Loss AmountInsurance Amount That Should Be Carried

So, again in our Office Building example, if our insured elected to take the premium for 80% coinsurance, but only insured his building for $20,000, here is the scenario. First of all, his premium would be only $42 ($20,000 x $.21 rate per $100). This is a bargain. Secondly, though, if he had a $10,000 loss, it would be settled as follows:

1. Amount that should be carried = $80,000 (i.e. 80% of $100,000)
2. Amount Actually Carried = $20,000
3. Loss Amount $10,000
4. Loss Payment = $20,000 divided by $80,000 = .25 Times $10,000 = $2,500

So our insured has saved a great deal of premium, however, his loss payment is only $2,500 instead of $10,000. I would say he was penny wise and pound-foolish.

So I guess the bottom line is that if you don’t take the premium credit associated with the coinsurance, then you don’t have to worry about the penalty for underinsurance. But why would you insure without coinsurance, when you can use the coinsurance credit to get a much larger amount of coverage for very little additional premium.