If you’ve ever purchased a homeowners policy or commercial property policy, then you’ve likely had a policy that contained a coinsurance clause. But what exactly is “coinsurance” and how does it affect you?
You likely already know that Business property insurance helps your business bounce back from disaster after a covered event, but it’s only as effective as your policy’s coverage limits. Failing to choose the correct property limits for your needs may leave you exposed to out-of-pocket expenses beyond your policy’s deductible.
In some cases, you may also be assessed a type of penalty, called coinsurance, for purchasing business property insurance without adequate property limits.
Coinsurance clauses have different meanings and intent depending on the type of insurance involved. For property insurance, whether it’s personal or commercial coverage, coinsurance is the means by which insurance companies compel a policyholder to purchase insurance coverage which accurately reflects the values of the property being insured.
A coinsurance clause generally requires the policyholder to maintain a limit of insurance that is equal to 80% of the property’s replacement value (i.e. what it would cost to totally reconstruct, restore or replace the property at the time of a loss). An 80% requirement is common but insurance companies sometimes require limits that are 90% or even 100% of replacement value. If the limit of insurance does not meet the requirements of the policy’s coinsurance clause, then the policyholder is penalized for the deficiency. The amount of the penalty is determined by a ratio of: [limit carried] / [limit required].
How exactly does a coinsurance clause work in business property insurance?
Scenario #1: A policyholder owns a building with a replacement cost of $1,000,000. His policy has an 80% coinsurance requirement which means the limit of insurance carried should be at least $800,000. The policyholder experiences a partial loss of $200,000.
- Policyholder carries a $1,000,000 limit of insurance. Limit meets coinsurance requirement. No penalty applies.
- Policyholder carries an $800,000 limit of insurance. Limit meets coinsurance requirement. No penalty applies.
- Policyholder carries a $600,000 limit of insurance. Penalty calculation 600,000/800,000 = .75 * 200,000 = loss payment of $150,000. A $50,000 penalty applies.
Scenario #2: A policyholder owns a building with a replacement cost of $1,000,000. His policy has an 80% coinsurance requirement which means the limit of insurance carried should be at least $800,000. The policyholder experiences a total loss of $1,000,000.
- Policyholder carries a $1,000,000 limit of insurance. Limit meets coinsurance requirement. No penalty applies.
- Policyholder carries an $800,000 limit of insurance. Limit meets coinsurance requirement. No penalty applies but loss payment will not exceed the $800,000 limit of insurance.
- Policyholder carries a 600,000 limit of insurance. Penalty calculation 600,000/800,000 = .75 * 1,000,000 = loss payment of $750,000. Regardless of the penalty loss payment will never exceed the limit of insurance.
REMEMBER: Loss payments will never exceed the limits of insurance, a point which really drives home the importance of insurance to value. Consider the 2nd and 3rd bullet points of scenario #2 above. The policyholder might receive the limits of insurance on the policy but now has to figure out how to replace a $1,000,000 building with only $600,000 – $800,000 in claim proceeds.
What exactly does “Insurance-to-Value” mean?
The concept of insurance-to-value is relatively simple. It means carrying a limit of insurance that is equal to the estimated replacement value of the property owned by the policyholder. Replacement value may not be the same as the market value (an estimate of what the property might be sold for in the current real estate market) or assessment value (the value assigned by taxing authorities where the property is located; used to determine property taxes).
Insurance-to-value (ITV) is a critical issue for the insurance industry and poses threats to both insurance carriers and policyholders alike.
Failure to insure both real and personal property to its replacement value can mean pricing based on faulty data which may negatively impact an insurance company’s long-term financial stability. For the policyholder property owner, it means out-of-pocket costs that could lead to major financial setbacks, potentially even business failure or bankruptcy.
Replacement value means the estimated cost to replace or rebuild a property at the time of the loss. This includes not only the cost of actual building materials and labor expenses, but also things like engineering and architect fees, cost to remove debris before reconstruction can begin, and the expense of upgrading to current building codes.
How do I determine my replacement value for my business property insurance?
There are a number of resources available for this:
- Property Appraiser – make sure to use an experienced, trusted, and reputable professional
- Property Valuation Tools sometimes referred to as “replacement cost calculators”
- Construction Experts
- Real Estate Experts
You might consider a combination of the above and other resources to give you a multi-faceted approach to determining your correct property values.
It’s also important to remember that property values are ever-changing. Improvements you make to the property, changes in construction costs, implementation of new technology, and many other factors can cause fluctuations in property valuation. Property values should be re-evaluated at least every 3 years and insurance limits adjusted accordingly.
Small business owners need to stay informed and protected from unexpected events and losses. Correct property valuations are clearly critical to obtaining adequate property insurance limits, thus avoiding consequences like coinsurance penalties and allowing you to focus on your business and your customers.
Coterie Insurance recognizes that business property insurance is complex. That’s why we recommend every small business works with a licensed insurance agent or broker in your area. Find one today!
