A book I’m considering writing, probably next year, is about how to make insurance more understandable, not only to policyholders, but also to the industry itself. For example, whether the use of a vehicle, from lawn mowers to watercraft and drones, is covered by a homeowners policy is an incredibly complex undertaking. I wrote about lawn mowers in my October 2020 column. There HAS to be a better way to limit the risks assumed by insurers while making insurance contract language easier to understand.
The same is true in commercial lines where ISO alone has over 30,000 mainstream policy forms and endorsements. One issue I’d like to address in this article is coinsurance. My first experience as an expert witness was a major shopping center fire where there was a substantial coinsurance penalty. Not only did the property owner claim he didn’t understand how coinsurance works, this excerpt from the agent’s deposition demonstrates that he too was lacking in understanding:
“You need, you need to know what coinsurance is a little bit deeper…I could give you the wrong thing, and I can stand to be corrected. But on coinsurance if you’ve got, like, a million dollars’ worth of coverage and if a person has an 80% coinsurance factor, all right, that means that it’s going to have to be sure that it is insured up to 80% of the value. That comes into play when it’s a partial claim is one thing that it will come into play. If a person is only insured up to 50% of the value instead of 80%, then it would be stated on the policy. Then there would be probably a 30% depreciation taken off the policy. So, the 80% is really better than a 90% coinsured or the coinsurance being 100%. And so that’s on that particular incident now. I mean, I’m….”
Apparently, this level of ignorance is not limited to the agency ranks. About a year ago, I got an email from an agency commercial lines account manager. A major carrier had just implemented a new policy whereby the building limit on a commercial property policy was now being set at the coinsurance percentage times the actual building value. For example, if the building has a $1 million replacement cost and property coverage is written at 90% coinsurance, the insurer will only insure the building for $900,000.
This represents an astonishing misunderstanding of coinsurance and it was shocking to me that apparently only the agent’s husband, a new underwriter at the carrier, had spoken up in the underwriting department about this. A $1 million building is often insured for that full value at an 80% or 90% coinsurance rate. One of the reasons someone might not select a 100% coinsurance rate is that property valuation is not an exact science and sometimes the replacement cost of property can increase in an unanticipated way.
For example, reconstruction costs can balloon following a widespread catastrophe like a hurricane. As a result, a 100% coinsurance clause could result in a penalty whereas an 80% or 90% coinsurance clause is less likely to do so. But you still want to insure to what is believed to be the full value of the building in the event of total or near total losses.
Is coinsurance a mid- to late-19th century concept whose time has passed? Perhaps, but for now we have to deal with it and explain it to property owners. The purpose of coinsurance is not to punish an insured for carrying inadequate insurance-to-value, though that may appear to be the result in the example above. Rather, its purpose is to provide a financial incentive to carry adequate limits for major losses and reward the insured with a premium reduction for doing so. To illustrate using real-life scenarios, the following is an example I used to give when I did property rating seminars.
The gross or flat property rate (“gross or flat” meaning no coinsurance requirement) of a $500,000 fire-resistive office building is $0.64 per $100 of coverage. The 80% coinsurance rate is $0.18. The premiums with and without coinsurance would be $900 and $3,200, respectively, a huge difference. If the building owner chose to only insure the building for $100,000, the premium without coinsurance would be $640. So, for an additional $260, the insured can increase the amount of coverage from $100,000 to the full value of $500,000. That decision for most property owners would be a no-brainer and we can thank coinsurance for making an offer the insured can’t refuse.
To contrast, let’s say an insured owns a $500,000 wood frame building used for woodworking and spray painting. The gross or flat rate is $3.74 and the 80% coinsurance rate is $3.37. Without doing the math, note that the rate difference is tiny. Why? From a coinsurance perspective, the building owner does not need much in the way of financial incentive to insure his building to value. Woodworking and spray painting in a wood frame building presents a dramatically greater exposure to a total fire loss than an office occupancy in a fire-resistive building. This is one of the main purposes of coinsurance.
Why do insureds need an incentive to insure to value beyond these examples? The reason is that most losses are partial. The last time I looked at a study published by the National Fire Protection Association (NFPA), it indicated that less than 2% of fire losses were total and 86% of fire losses resulted in damages of 20% or less of the building value. So, for a $500,000 building there would be almost a 90% chance that a fire loss would amount to $100,000 or less.
In that case, if the property owner is a risk taker, why not insure for $100,000 or less? The answer is the same for people who only want to buy minimum financial responsibility auto liability limits. While the chance of a major loss is relatively low, such losses do happen and they can bankrupt you. Plus, in the case of property insurance, there are other perils to consider such was windstorm, water damage, etc.
Coinsurance, as complicated and difficult to understand as it is, provides an incentive to insure to value. The question for another day might be, isn’t there an easier, more transparent way to do this? In the meantime, perhaps this article will help you explain the purpose of the coinsurance clause.
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