AAIS COVERAGE PERSPECTIVE
By Robert J. Prahl, CPCU
Help your clients understand the concept
and buy the coverage they need
In an effort to avoid ... inequity and to encourage insureds to carry a reasonable amount of insurance in relation to the actual cash value (or replacement value) of their property, a coinsurance requirement is incorporated into many commercial property insurance policies.
Have you ever been asked to explain the purpose of coinsurance or to give an example of how it is applied? If so, you may have developed a good explanation of the concept with a practical example that demonstrates its application. However, if you haven't developed such a response or haven't yet been asked to explain it, you may benefit from the following definition:
Coinsurance can be described as a property insurance provision that imposes a penalty on an insured's loss recovery if the limit of insurance purchased is not at least equal to a specified percentage of the value of the insured property.
Why is a coinsurance provision necessary?
It is well established that most building property losses are partial in that they do not result in the total destruction of the structures involved. For insureds who recognize this, there may be a tendency to play the odds and limit the amount of insurance purchased. Why pay the premium for full coverage when chances are the full amount may never be needed? Of course, when the property is pledged as security for a mortgage loan, the mortgage company usually requires that the property be insured for an amount that will cover the balance of the mortgage. Even then, however, there may be some latitude in estimating the value of the property in question.
Since it is true that most losses are partial, individuals who purchase full coverage ordinarily would pay an inordinately higher premium than those who play the odds and limit the amount of their insurance. Therefore, insureds with full coverage would pay an inequitable premium.
In an effort to avoid this inequity and to encourage insureds to carry a reasonable amount of insurance in relation to the actual cash value (or replacement value) of their property, a coinsurance requirement is incorporated into many commercial property insurance policies. The insured receives the benefit of a reduced rate when the limit is equal to a specified coinsurance percentage (commonly 80%).
The rates ordinarily used for insuring commercial buildings and personal property are calculated with the assumption that they will be used with an 80% coinsurance provision. When a policy contains a higher coinsurance percentage, the 80% coinsurance rate is reduced to encourage the insured to purchase higher limits. Therefore, with 90% or 100% coinsurance, the insured must purchase a greater amount of insurance to comply with coinsurance, but the rate is reduced. When there is no coinsurance requirement, or when it is less than 80%, the rate is increased.
For the company, encouraging insureds to carry an amount of insurance that more closely approximates the value of their property also helps ensure that sufficient premium will be collected to pay losses as they occur.
For the policyholder, it offers peace of mind that the likelihood of a penalty being imposed in a loss situation is diminished, if not eliminated.
Coinsurance limits the amount the insurer must pay for damaged property to that proportion of the loss that the amount of insurance bears to a specific percentage of the value of the property at the time of loss.
The coinsurance provision in the AAIS Commercial Property policy (CP-12 Ed 1.0) includes an example of how it applies built right into the policy:
If the insured purchases insurance at least equal to the coinsurance percentage (say 80%), the insurer pays the full value of any loss (either replacement cost or actual cash value, depending on what the insured has purchased), up to the limit of insurance. If the insured does not meet the coinsurance requirement, he or she will be penalized in the event of a loss and will become a coinsurer.
The formula used to determine the amount payable when a coinsurance provision applies is:
| Amount of insurance carried X Loss = | Amount |
| Amount of insurance required | recoverable |
Application of deductible
In the AAIS Commercial Property coinsurance provision, the deductible is subtracted from the loss before application of the coinsurance percentage. This yields a larger adjusted claim payable to the insured than if the deductible were subtracted after application of the coinsurance percentage.
Note that it is not mandatory that the insured carry insurance up to the specific percentage, but if the insured does not comply, a penalty will be imposed in the adjustment of the loss. Conversely, if the insured carries insurance that meets the coinsurance percentage, the full value of the loss will be paid up to the policy limit.
Insurance to value requirements in homeowners insurance
The "insurance to value" requirements of the replacement cost provision in a homeowners policy, while technically not coinsurance, are similar to the coinsurance provision in the commercial property policy. The similarity lies in the fact that if the 80% insurance to value requirement is not met, recovery may be based on the proportion of the cost to repair or replace represented by the amount of insurance carried divided by 80% of the replacement cost. Under the homeowners policy, however, the minimum amount received will never be based on an amount that is less than the actual cash value of the property (which can occur with the Commercial Property policy).
The applicable provisions in the AAIS standard homeowners policy are paragraphs d) and e) under Loss Settlement Terms.
d) If the "limit" on the damaged building is less than 80% of its replacement cost at the time of loss, the larger of the following amounts is used in applying the "terms" under Our Limit:
(1) the actual cash value at the time of the loss; or
(2) that part of the replacement cost of the damaged part which "our" "limit" on the building bears to 80% of the full current replacement cost of the building.
e) If the "limit" on the damaged building is at least 80% of its replacement cost at the time of loss, the smaller of the following amounts is used in applying the "terms" under Our Limit:
(1) the cost to repair or replace the damage on the same premises using materials of like kind and quality, to the extent practical; or
(2) the amount spent to repair or replace the damage.
In the AAIS Homeowners policy, the cost of such property as excavations, piers, other supports, and underground pipes, wiring, etc., is not included in determining the replacement cost. This provision is added because this property ordinarily survives a loss.
Let's use an example of damage to a roof to demonstrate how the insurance to value provision is applied, first addressing a loss situation in which the insured has not met the insurance to value requirement.
Suppose, for example, the following facts apply:
* The replacement value of the house is $300,000
* The amount of insurance is $210,000
* The full cost to replace the wind-damaged roof, without deduction for depreciation, is $8,000
* The actual cash value of the roof (after depreciation) is $7,250
* The insured carries a deductible of $500
In order to comply with the insurance to value provision, the insured would have had to insure the home for $240,000 (80% of $300,000). The limit carried is $210,000 and, as a result, paragraph d) above applies. The insurer therefore will pay the larger of the actual cash value or the fraction or proportion of insurance carried to insurance required. The actual cash value of the damaged roof is given at $7,250.
In this first example, we need to determine the proportion of the loss that the amount of insurance carried bears to the amount of insurance required to determine if that amount is larger than the actual cash value of $7,250.
To determine that proportion, the following formula applies:
| Amount of | Replacement | |
| insurance carried | X | cost of roof = Amount payable |
| 80% of replacement | ||
| cost of bldg |
Using the formula, the figures are:
$210,000 (.875) X $8,000 = $7,000
$240,000
$7,000 - $500 deductible = $6,500
Amount payable
The policy does not specify whether the deductible is to be taken before or after the proportion (fraction) is calculated. Barring any case law or regulations to the contrary, it is the insurer's option of the company whether it applies the deductible before the proportion is applied or after. In the above example, the deductible was taken after the proportion was applied to arrive at the $6,500 amount payable. If the deductible were subtracted before application of the proportion, the amount payable would be $6,562.50. (The insured gets a slight advantage when the deductible is applied first.)
$210,000 X $7,500 = $6,562.50
$240,000
In both instances, the actual cash value of $7,250 is the larger figure, so that amount, less the $500 deductible, is the amount payable for this loss.
Next, let's look at an example in which the larger amount is the insurance to value proportion.
Assume the same replacement value of $300,000, the same limit of insurance at $210,000, and the same $500 deductible. However, the full cost to replace the roof, without deduction for depreciation, is $6,000 and the actual cash value of the roof (after depreciation) is $4,000.
We know the actual cash value is $4,000. To calculate the proportion, the figures are:
$210,000 X $6,000 = $5,250
$240,000
$5,250 - $500 = $4,750
If the deductible were subtracted before application of the proportion, the amount payable would be $4,812.50:
$210,000 X $5,500 = $4,812.50
$240,000
Either way, the figure exceeds the actual cash value loss of $4,000, so the insurer will pay the figure computed from using the formula. (Keep in mind that if the insured met the 80% replacement cost requirement and insured for $240,000, the full replacement cost of $6,000--less the applicable deductible--would have been paid.)
It must be emphasized that a loss will not be paid on a replacement cost basis (without deduction for depreciation) unless the damages are actually repaired or replaced. Until repair or replacement is completed (or, in actual practice, usually once work is started), the loss is adjusted on an actual cash value basis, that is, with a deduction for depreciation. The insured has six months in which to make claim on a replacement cost basis. However, there is an exception to this provision. If the cost to repair or replace does not exceed $2,500 or 5% of the limit on the damaged building, whichever is less, the loss may be settled on a replacement cost basis from the outset.
By obtaining proper coinsurance and insurance to value, companies can reduce underinsurance, increase premium revenues and, in the process, improve their combined ratios. Agents and brokers can provide a valuable service to their clients by explaining these concepts and encouraging the purchase of appropriate amounts of insurance. *
The author
Robert J. Prahl, CPCU, recently retired as director of education for the American Association of Insurance Services. The "AAIS Coverage Perspective" column will continue with other authors from AAIS.