130.6-9

COINSURANCE CLAUSE

(December 2008)

INTRODUCTION

Coinsurance is the way the insured that insures to value is rewarded and the way the insured that does not is penalized. Property rates include a credit that assumes 80% coinsurance. An additional rate credit applies if the insured agrees to subject itself to 90% or 100% coinsurance. On the other hand, the rate is surcharged if an insured decides not to agree to submit to the coinsurance condition. In addition, certain property extensions in the coverage form or policy apply only if the insured selects the coinsurance condition. Since the insurance company provides these incentives without confirming that the insured met the requirement, the insured incurs a penalty if it does not.

The coinsurance penalty is the “stick” in the “carrot and stick” approach to encourage adequate insurance to value. The insured that does not do so becomes a co-insurer when a loss occurs.

COINSURANCE

Three specific types of information are needed to determine if a coinsurance penalty applies:

• The value of the covered property at the time of loss

Note: The value as of the policy inception date is irrelevant.

Example: The Kelley Hardware property coverage form insures stock and other business personal property valued at $100,000 as of the inception date. Kelley selects 80% coinsurance and purchases an $80,000 limit with a $1,000 deductible. At the time of a fire three months into the policy term, the total value of stock and other business personal property is $120,000. The fire loss is $50,000. The value used when considering applying the coinsurance penalty is the $120,000 at the time of loss, not the $100,000 on the inception date.

• The coinsurance percentage selected

As indicated above, the coinsurance percentages available are 80%, 90% or 100%. In some cases, the insured can select no coinsurance but doing so requires a rate surcharge instead of a credit. Since loss costs are developed using 80% coinsurance, no surcharge or credit applies for 80% coinsurance. 90% coinsurance receives a credit of 5% and 100% coinsurance is credited 10%.

• The limit of insurance does not have to be the value multiplied by the coinsurance percentage.

The limit of insurance should reflect the maximum expected value of the covered property during the policy period. If significant value fluctuations are likely, the insured should consider writing coverage on a reporting form basis or using the peak season endorsement in cases where the values peak at specific times. Please refer to PF&M Section 130.6-11, Value Reporting Form, for more information on reporting forms. Please refer to PF&M Section 130.6-12, Peak Season Coverage, for more information on covering peak values at specific times of the year. The insured may insure for the 100% values but write the coverage at 80% coinsurance or 90% coinsurance to be more certain of avoiding a coinsurance penalty.

Example: The Kelley Hardware limit should be $96,000. This is based on the $120,000 value at the time of loss multiplied by 80%. However, Kelley selected an $80,000 limit at 80% coinsurance and a coinsurance penalty applies.

CALCULATING THE PENALTY

The coinsurance penalty is determined by a four-step formula:

Step 1: Multiply the actual value of the property at the time of loss by the coinsurance percentage.

Step 2: Divide the limit of insurance for the location and coverage by the result in Step 2.

Step 3: Multiply the loss amount by the result in Step 3.

Step 4: Subtract the deductible amount from result in Step 4.

The insurance company pays the lesser of the amount determined in Step 4 or the limit of insurance. The insured is responsible for the remaining loss amount.

Example: Kelley Hardware incurs a coinsurance penalty in this case, calculated as follows:

Step 1: $120,000 X .80 = $96,000

Step 2: $80,000 / $96,000 =.833

Step 3: $50,000 x .833 = $41,650

Step 4: $41,650 - $1,000 = $40,650

The insurance company pays $40,650. The remaining $9,350 is Kelley Hardware's responsibility.

ADDITIONAL COINSURANCE REQUIREMENT EXAMPLES

A way to remember the coinsurance penalty formula is DID / SHOULD X Loss. The amount of insurance carried (DID) is divided by the amount that SHOULD have been carried. This resulting percentage is multiplied by the amount of LOSS to determine the amount the insurance company pays. The following examples illustrate the development and application of the penalty.

Example 1 (Adequate Insurance)

$250,000 property value at time of loss

80% coinsurance percentage for the coverage

$200,000 limit of insurance carried (DID)

$500 deductible

$40,000 amount of loss

Step 1: $250,000 X 80% = $200,000 (SHOULD)

Step 2: $200,000 / $200,000 = 1.00 (DID / SHOULD)

Step 3: $40,000 X 1.00 = $40,000

Step 4: $40,000 - $500 = $39,500.

The insured is paid the amount of loss minus the deductible. In this case, the insured was insured to value.

Example 2 (Inadequate Insurance)

$250,000 property value at time of loss

80% coinsurance percentage for the coverage

$100,000 limit of insurance carried (DID)

$500 deductible

$40,000 amount of loss

Step 1: $250,000 X 80% = $200,000 (SHOULD)

Step 2: $100,000 / $200,000 = .50 (DID / SHOULD)

Step 3: $40,000 X .50 = $20,000

Step 4: $20,000 - $ 500 = $19,500.

The insurance company pays $19,500, its share after applying the 50% coinsurance penalty reduced by the amount of the deductible. The insured is a co-insurer for the remaining $20,500 because it did insure to value.

Example 3 (Over-insurance)

$250,000 property value at time of loss

80% coinsurance percentage for the coverage

$300,000 limit of insurance carried (DID)

$500 deductible

$40,000 amount of loss

Step 1: $250,000 X 80% = $200,000 (SHOULD)

Step 2: $300,000 / $200,000 = 1.50 (DID / SHOULD)

The calculations stop at this point. A coinsurance penalty does not apply when the percentage is 1.00 or higher. On the other hand, because insurance is a contract of indemnity, the insured does not receive a bonus or additional consideration for over-insuring. The insured is paid $40,000 - $500 = $39,500.

Example 4 (Blanket)

Blanket insurance on multiple items of property is permitted. However, when this coverage is written subject to a coinsurance percentage, the percentage selected applies to every item of property included in the blanket. As a result, and in order to calculate the penalty, every property item in the blanket must have its values calculated at the time of loss to determine the penalty, if any, even if the loss involves only one item of property.

The property values at time of loss are:

$275,000 Building at Location 1

$100,000 Personal Property at Location 1

$75,000 Personal Property at Location 2

$450,000 Total Values

90% Coinsurance for the blanket

$350,000 Total limit of insurance carried

$1,000 Deductible

$85,000 Building amount of loss

$20,000 Personal Property amount of loss

$105,000 Total loss

Step 1: $450,000 X 90% = $405,000 (SHOULD)

Step 2: $350,000 / $405,000 = .864 (DID / SHOULD)

Step 3: $105,000 X .864 = $90,720

Step 4: $90,720 - $1,000 = $89,720

The insurance company pays $89,720, its share after application of the coinsurance penalty reduced by the amount of the deductible. The insured is a co-insurer for the remaining $15,280 because it did not keep its promise to insure to value.

BLANKET INSURANCE

Most insurance company rules require use of a 90% or 100% coinsurance clause in conjunction with an annual statement of values when coverage is written on a blanket basis. Blanket coverage applies to two or more coverages or two or more separate buildings or fire divisions for a single limit of insurance. Please refer to PF&M Section
130.6-18, Blanket Property Insurance, for more information about blanket property insurance.

VALUATION OF PROPERTY

Coinsurance can apply based on either actual cash value or replacement cost valuation. If it is used with replacement cost valuation, the insured must review the values regularly and keep them as current as possible. An automatic percentage increase should be used for buildings. Personal property should be subject to regular inventory checks to maintain proper insurance to value and to avoid underinsurance. Allowing a policy to renew “as is,” almost guarantees a coinsurance penalty for being underinsured if a loss occurs.

AGREED VALUE COVERAGE OPTION

Agreed Value is a coverage option available with the Building And Personal Property Coverage Form. It requires that the insured and the insurer agree on the full value of certain property before a loss occurs. Any covered loss is adjusted based on that agreed upon value. When the Agreed Value Coverage Option is used, the coinsurance condition is waived because the agreed value arrangement supersedes and replaces coinsurance.

Note: The agreed value is subject to time limitations. The inception and expiration dates of this valuation agreement are indicated on the declarations. This gives the parties the opportunity to review the amount selected at specified intervals to determine if it is still adequate.

EXPLANATION OF COINSURANCE

If the insured finds understanding coinsurance difficult, this explanation may help.

Insurance policies are promises of utmost good faith. The insured believes the insurance company will keep its promise to indemnify in return for the premium paid. The insurance company believes the insured is honest with the information provided on the application. The premium the insured pays is based on the statements it made on the application. However, there are ramifications when a promise made is broken.

The property premium is calculated using the limits the insured provides with the understanding that they are accurate. If they are not, the premium is insufficient. If enough insureds misrepresent their values, the insurance company does not collect enough in premiums to keep its promises to pay. Rather than voiding a policy because of inadequate values, the insurance company chooses only to penalize the insured and essentially say, “Since you didn’t keep your part of the bargain, we will honor only part of ours.”