The coinsurance clause and how underinsurance is penalized

A coinsurance clause says you must insure property to a stated percentage of its value, usually 80%, 90% or 100%, or the insurer will pay only a proportional share of every loss, including small ones. If your limit is below the required amount, you become a co-insurer of the difference and absorb part of the loss yourself. It is the most common reason a commercial property claim pays less than the owner expects.

The formula in the standard form

The ISO Building and Personal Property form (CP 00 10 10 12) applies the condition when the declarations show a coinsurance percentage. It compares your limit to the value of the covered property at the time of loss multiplied by that percentage. If the limit is smaller, the insurer pays by this sequence:

1. Multiply the value of the property at the time of loss by the coinsurance percentage. That is the amount of insurance you needed.
2. Divide your limit by that figure. That is the ratio you are paying on.
3. Multiply the total loss, before the deductible, by the ratio.
4. Subtract the deductible.

The insurer pays the result or the limit, whichever is less. The form says plainly that for the remainder "you will either have to rely on other insurance or absorb the loss yourself." Note the order: the penalty is applied to the loss before the deductible, and then the deductible is subtracted, so you bear both. Note also that "value" is measured at the time of loss, not when you bought the policy, which is why a building limit that was adequate in January can be short by the fall after a year of rising construction costs.

A worked example (hypothetical)

Say a machine shop owner insures her building for $900,000 on a replacement cost basis with a 90% coinsurance clause and a $5,000 deductible. When a kitchen fire hits the break room, the cost to rebuild the building at the time of loss turns out to be $1.5 million, and the fire loss is $120,000.

• Required insurance: $1,500,000 x 90% = $1,350,000.
• Ratio: $900,000 / $1,350,000 = 0.667.
• Loss after penalty: $120,000 x 0.667 = $80,000.
• Less deductible: $75,000 paid.

She absorbs $45,000 on what feels like a modest loss. Here is the same fire at three different limits.

The penalty applies to partial losses, not only total losses. In a total loss the payment is capped at the limit anyway, so the owner of an underinsured building discovers the problem in the ordinary claims, not just the catastrophic one. The coinsurance penalty calculator lets you run your own figures.

Blanket limits and multiple items

Coinsurance is tested item by item when separate limits apply (building and contents are separate items). If one limit covers two or more items, the condition applies to the total value of everything under that limit. The form's own illustration has a blanket limit over two buildings and the contents of one: the values add up, the percentage is applied to the total, and a shortfall on the combined figure reduces the payment on whichever item is damaged. Blanket limits come with their own traps, covered in agreed value, blanket limits and margin clauses.

Coinsurance on business income

Business income coverage has its own clause. In the CP 00 30 10 12 form, the test is your Business Income limit against the coinsurance percentage times the sum of net income (net profit or loss before income taxes) and operating expenses, including payroll, that you would have earned or incurred at the described premises over the 12 months following inception or the last policy anniversary, whichever is later. Certain expenses are deducted from operating expenses for the test, including cost of merchandise sold, cost of raw stock and supplies consumed, discounts, bad debts, and services purchased from outsiders to resell that do not continue under contract. The same four-step proportion applies.

A hypothetical: net income plus operating expenses for the policy year would have been $800,000 and the coinsurance percentage is 60%. The required limit is $480,000. If the limit is $240,000, the ratio is 0.50, and a $100,000 loss pays $50,000. The form's condition does not apply to Extra Expense coverage. how to calculate a business income limit shows how to build the figure, and business interruption insurance: how business income coverage works covers the coverage itself.

What coinsurance does not touch

The coverage extensions in CP 00 10 (newly acquired property, valuable papers, off-premises property, outdoor property and the others) are not subject to coinsurance, and each has its own dollar limit. They are available, though, only when the declarations show a coinsurance percentage of 80% or more (or a value reporting symbol), so a lower percentage can quietly switch them off. commercial property insurance: what it covers and what it doesn't lists them.

Four ways to avoid the penalty

1. Insure to value, honestly. Set the limit at the replacement cost of the building and contents, using a current valuation rather than the purchase price, the tax assessment or the market value. insurance to value: setting the right building limit explains how.
2. Buy Agreed Value. This optional coverage suspends coinsurance for the property it covers. You submit a statement of values supporting the figure, and the insurer shows an agreed value in the declarations. If your limit is at least the agreed value, losses are paid in full up to the limit; if it is lower, payment is cut in proportion. It lapses if the expiration date in the declarations is not extended, and coinsurance comes back.
3. Add Inflation Guard. The form can raise the limit automatically by an annual percentage shown in the declarations, prorated by days. A $100,000 limit with 8% would grow by $3,200 after 146 days. It tracks a percentage you choose, not actual cost inflation, so it supplements a revaluation and does not replace one.
4. Report values if inventory swings. Where stock peaks seasonally, ask about a value reporting arrangement, in which you report inventory values periodically and the premium follows what you report. These arrangements typically carry their own penalty for under-reporting, so the reporting discipline matters.

Also revisit the limit whenever you renovate, add equipment or buy property, and ask whether the limit is on replacement cost or actual cash value. Moving from one to the other changes the value in the coinsurance formula; see replacement cost vs actual cash value for business property.

Choosing a percentage

Insurers generally give a rate credit for higher coinsurance percentages, so the rate per $100 of insurance falls as you move from 80% toward 100%, while the premium rises with the larger limit you must carry. A higher percentage also leaves less room for valuation error: at 100% you need the full replacement cost to avoid any penalty, while at 80% a limit that is 20% short of value still passes. The practical comparison is the cost of the extra limit against the cushion it buys. Ask your broker to show quotes at each percentage, and the penalty at a few loss sizes.

Key takeaways

• Coinsurance requires you to carry a set percentage of the property's value at the time of loss; below that, every claim is reduced proportionally.
• The penalty applies to partial losses, is calculated before the deductible, and is based on current value, so a year of cost inflation can create it.
• Business income has its own clause, based on net income plus operating expenses for the next 12 months, and Extra Expense is not subject to it.
• Agreed Value, an accurate valuation, Inflation Guard and value reporting are the ways to keep the penalty off the table.
• Treat the limit as a number to revisit at every renewal, not a figure that carries forward.