Understanding the Coinsurance Clause
In the world of property insurance, the coinsurance clause is a common provision that encourages policyholders to insure their property for its full value or a high percentage of it. For candidates preparing for the complete P&C exam guide, understanding how this clause impacts claim settlements is essential.
Essentially, coinsurance requires the insured to maintain a specific limit of insurance—usually 80%, 90%, or 100% of the property's actual cash value or replacement cost. If the policyholder fails to meet this requirement and a loss occurs, they become a "co-insurer" for the loss, meaning they must share the financial burden with the insurance company through a penalty.
Why Insurance Companies Use Coinsurance
Insurance rates are calculated based on the assumption that most losses are partial, not total. If everyone only insured their buildings for 50% of their value, the insurance company wouldn't collect enough premium to cover the risk. Coinsurance ensures that premiums are equitable across all policyholders based on the true value at risk.
The Coinsurance Formula: 'Did over Should'
The most important concept to memorize for the property and casualty exam is the coinsurance formula. It is often referred to as the "Did over Should" formula. This calculation determines the amount an insurer will pay for a partial loss when the property is underinsured.
The mathematical representation is:
- (Amount of Insurance Carried / Amount of Insurance Required) x Amount of Loss = Claim Payment
Note that the final payment can never exceed the policy limit or the actual amount of the loss. Additionally, the deductible is typically subtracted from the final result of this formula.
Key Variables in the Formula
Step-by-Step Calculation Example
Let's walk through a scenario you might encounter when using practice P&C questions to study. Imagine a commercial building with a Replacement Cost of $500,000 and an 80% coinsurance clause.
Step 1: Determine the 'Should'. Multiply the replacement cost by the coinsurance percentage.
$500,000 x 0.80 = $400,000. the insured should carry at least $400,000 in coverage.
Step 2: Identify the 'Did'. In this example, the insured only purchased $300,000 in coverage.
Step 3: Apply the Formula. If the building suffers a $100,000 loss, the calculation is:
($300,000 / $400,000) x $100,000 = $75,000.
In this case, the insurance company pays $75,000 (minus any deductible), and the policyholder is responsible for the remaining $25,000 because they were underinsured.
Impact of Underinsurance on Payouts
| Feature | Scenario | Calculation Result |
|---|---|---|
| Insured at 100% of Requirement | Full Payout (up to limit) | 100% of Loss Paid |
| Insured at 50% of Requirement | 50% of Loss Paid | 50% Penalty |
| Total Loss Scenario | Policy Limit is Paid | Coinsurance doesn't reduce total loss |
Total Loss vs. Partial Loss
One nuance often tested on the exam is how coinsurance applies to total losses. The coinsurance penalty typically applies only to partial losses. If a building is valued at $500,000, required to be insured for $400,000, but only insured for $300,000, and it burns to the ground (a total loss), the insurer will simply pay the policy limit of $300,000.
The penalty exists to prevent people from buying a small amount of insurance to cover small losses while paying a fraction of the premium required for the total exposure.
Frequently Asked Questions
If you carry an amount of insurance equal to or greater than the percentage required by the policy, the coinsurance clause does not apply. Your losses will be paid in full, up to the limit of the policy, minus your deductible.
Standard industry practice is to apply the coinsurance formula to the loss first, and then subtract the deductible from that result. However, some specific policy forms may vary, so always read the specific exam question carefully.
It depends on the policy valuation method. If the policy is written on a Replacement Cost basis, the 'Should' is calculated based on the replacement cost. If it is an ACV policy, the requirement is based on the actual cash value at the time of the loss.
No. A deductible is a fixed dollar amount (or small percentage) the insured pays on every claim. Coinsurance is a penalty that only triggers if the insured failed to buy enough total coverage relative to the property's value.