Coinsurance
Calculator
An Example —
Calculating the Property
Coinsurance Penalty
A business partially insures
property worth $1,000,000 for
$400,000, with a policy that
requires at least 80% of its
value to be insured for full
coverage, and which has a
$20,000 deductible. The
business suffers a $200,000
loss. Since the amount of
insurance required for full
coverage equals the following
--- .8 x $1,000,000 = $800,000
--- the business would have to
pay 1/2 of that loss, since the
property was only insured for
half of the required amount of
insurance. Using the above
equation, $200,000 x
$400,000/$800,000 - $20,000 =
$80,000. The claim recovery in
this example will be $80,000.
The insured's coinsurance
'penalty' --- excluding the
deductible --- is $100,000.
About Coinsurance
"Coinsurance" is a common
provision in commercial
property policies. Simply
stated, coinsurance is a
methodology by which the
insurance carrier can guarantee
that the insured
("policyholder") carries the
property insurance/limits on
the insured property.
coinsurance requires the
insured to pay a certain
percentage of her losses or
expenses on an inversely
proportional basis to the value
of the property that is
insured. Coinsurance exists in
property insurance because
premiums are based on loss
frequency ("number of claims")
and loss severity ("amount of
claims").
However, in commercial
property insurance, total
losses are far less frequent
than partial losses. Therefore,
the premium rate that is
charged - per $100 of property
value - will be less for a
total loss than the premium
rate charged - per $100 of
property value - for a partial
loss. Without coinsurance, some
insureds would only insure for
partial losses, since partial
losses are more likely to
occur. The premium for the very
significant 'total' loss would,
therefore, be low and the
insurance company would not be
collecting an adequate charge
for the coverage. This can be
somewhat confusing. But
coinsurance exists to ensure
for equity in rating and for
the collection of adequate
premium(s) by the insurance
company.
Insurance companies
generally require property to
be insured by at least a
certain amount—usually
80% of its value. [That means,
for a $1,000,000 building, the
insured must insure the
property for no less than
$800,000.) If the insured value
is lower than this amount - and
there is a loss - then the
insured will have to pay a
percentage of the loss equal to
the percentage of his carried
insurance over the required
insurance. This is referred to
as a 'coinsurance penalty'.
(Some Background: The 80%
figure rather than the 100%
figure is used to account for
inflation. Since most property
values rise over time, if a
policy had a 100% coinsurance
requirement - and the insured
purchased it in good faith - a
coinsurance payment could still
be required for a loss because
values increased during the
term.) However, if the insured
paid for coverage that was
greater than the value of the
property, then she would be
paying higher premiums than are
necessary for the property.
Since insurance companies never
pay more than actual cash value
or replacement cost for the
property, the insured would not
benefit from overinsurance,
which is paying for coverage
that is greater than the value
of the property.
In Summary, How Coinsurance
Yields Fair Premiums:
- Premiums are determined
loss frequency and loss
severity with property
insurance premiums based on
$100 units (increments) of
property value.
- Partial losses are
always more frequent than
total losses. Therefore,
the 1st unit is always lost
in any loss event, but the
last unit of a property
will only be lost if it is
a total loss.
- The premium needed to
cover losses, if each $100
unit of value were
considered separately, for
the 1st unit would be much
higher than for the last
unit. The average premium
needed to cover losses
would decline continuously
for each additional unit
that is insured.
- Since underwriting
risks and premiums are
determined from actuarial
studies of 'real' risks, a
premium rate cannot easily
be determined separately
for each $100 unit of
property and an average
rate must be used.
- If the premium were set
to cover the 1st unit of
loss or the average loss,
then people who wanted
complete coverage would pay
too much. This would be a
detriment to the
policyholder
("insured")
- If the premium was
determined that would
insure the entire property,
then many people would save
money by insuring only part
of the value of their
property (since total
losses are rare). In this
case, the insurance company
does not collect enough
premium for the risk.
- Property coinsurance
allows insurers to quote a
single premium that is
contingent only on the
amount. People who would
insure for less than the
required amount would have
to pay a coinsurance
penalty that is
commensurate with the
underinsurance.
Commercial Coinsurance Calculation Explained (PDF)
