Who put the co in co-insurance.

In an earlier column we told the sad story of a building owner who suffered a substantial out-of-pocket loss after a major fire. His problem in part was that he had unwittingly become a co-insurer, in effect, a partner with his insurance company in the settlement of his loss. There is probably no insurance issue more universally misunderstood among property owners than the co-insurance clause. One reason for this is that the logic for the imposition of the coinsurance provision is rarely explained. It is not a nefarious trick on the part of the carriers, or a conspiracy of loss adjusters and agents. In fact, the irony is that while the clause frequently operates to penalize the policyholder, its intent is to protect all insureds. Let's start at the beginning.

We're All In This Together 

If you'll permit us a tongue-twister, insurance is a socio-economic phenomenon. In other words, insurance only exists to protect the members of society from financial harm. An insurance policy can't make fires stop happening, but it can relieve the victim of the economic pain which ensues. It does this successfully only in combination with many other policies held by many others in the community. The risk of the cost to any one policyholder is spread among many other potential sufferers of the same kind of loss. They all ante up a premium, and, in this case, the loser gets the kitty, and the relief from possible ruin. The problem we're addressing comes in here: How do we make sure that each participant has paid in a fair amount, given the likelihood that a particular property will suffer the loss which the other participants are going to share?

Rates

The first and simplest initial answer is by the "rate", or unit cost. Obviously, the operator of a grain elevator or an unprotected paint factory should have to pay a higher premium rate than the owner of a sprinklered warehouse storing clock radios. And, similarly, fire-resistive buildings should cost less to insure than frame buildings. The rate charged reflects the relative chances of a loss occurring given varying occupancy and construction factors. But a rate can not accurately reflect the likelihood of a loss of a given size occurring in one of two similarly constructed and occupied buildings which differ only in their value. By way of illustration, in a 60-unit brick apartment building in the Bronx worth, say $2 million to rebuild at today's costs, there is a greater opportunity for a fire to start somewhere in the building and spread causing $50,000 in damage than for the same thing to happen in a six-unit building across the street with a value of $200,000. But the rate for these two exposures might be the same, let's say 50 cents for every $100 of insurance.

A Matter of Fairness

The owner of the $200,000 building wants to insure himself in full, so he buys a policy for $200,000 and pays a premium of $1,000 (.50 per $100 x $200,000). The owner of the $2 million building, a gambler, feels that his building will never burn to the ground, and he decides that he'll also buy only a $200,000 policy, and he pays the same $1,000 premium. Simply because the $2 million dollar man is willing to self-insure most of a full loss should not entitle him to collect on that possible $50,000 partial loss when he's only paid into the kitty the same $1,000 as his more prudent and smaller neighbor across the street. It would be an unfair allocation of risk and reward. The intent of the co-insurance clause is to take from each according to his ability in order to return to each according to his need. The objective is equity, not penalty.

The Formula

The mechanism used in the policy to achieve this objective is a formula which is expressed in the co-insurance clause. The policyholder is required to purchase an amount of insurance equal to at least a certain percentage of the value of the insured property (usually 80 percent) or suffer a proportionate "penalty" to the extent he underinsures. To return to our two building owners, the owner of the $2 million building should be required to purchase at least $1.6 million in insurance. The $200,000 owner need take only $160,000. At the .50 rate the policy for the larger building would cost $8,000, the smaller, $800- that seems more reasonable. As it stands, the $2 million gambler, has grossly underinsured his building and grossly underfunded the community "pool" needed to pay claims. His $50,000 loss will thus be treated as follows pursuant to the formula:

Value $2,000,000

Amount of Insurance

Required at 80% 1,600,000

Amount actually purchased 200,000 (1/8th the required amount)

Loss Suffered 50,000

1/8 x $50,000=$6,250

In this case, the $43,750 co-insurance penalty could have been avoided had the insured simply bought the $1.6 million required amount of insurance. The additional cost above the $200,000 he bought would have been $7,000 ($1,400,000 x .50 per $100)!

Valuation is Not the Issue

Don't confuse the issue of adequate insurance with that of valuation: in the example above, the amounts discussed represent the replacement cost value of the property with no deduction taken for physical depreciation based on age or condition. But even if the coverage had been written on an Actual Cash Value basis, with depreciation factors amounting to 30 percent for example, the co-insurance requirement would still be applicable, simply to the lesser amounts.

Relief is Available

Let's move from the theoretical to the practical. At this particular time we are in a "soft" market for insurance pricing, with many fine carriers (and some not so fine) aggressively competing for your business. They are still insisting, as they must, that each insured carry his weight by insuring to value; but for the wise buyer who will take the time to determine the correct value of his property (whether on a replacement cost or actual cash value basis) and purchase the appropriate amount of insurance, carriers will eliminate the co-insurance clause and add instead an "agreed amount clause".

Under the latter provision, the carrier, in effect, agrees in advance that the amount of insurance taken represents a fair and acceptable approximation of the physical value of the property (80 percent will usually suffice). It does not guarantee the result of any particular loss settlement, and, of course, you'll never collect more than the amount of your policy limit. But it does assure you that the amount of insurance you bought at the outset will not be called into question and used against you at the time of a loss. There is no additional charge for the agreed amount clause - you simply have to purchase and pay for the proper amount of coverage.

Now What?

An insurance agent or broker can help you through this muddle in some important ways: 1. He'll review your policy to determine if it contains a coinsurance clause 2. He'll discuss your property exposures with you and help determine the correct valuation 3. He'll negotiate on your behalf with insurance carriers to secure properly structured protection

As we've said in this column before, insurance policies are complex contracts -- use a professional to get help -- they're ready and eager to do business.

Marc Cohen is an account executive with Kaye Insurance Associates. He specializes in Kaye's comprehensive multiperil insurance program especially designed for residential real estate properties. Kaye Insurance Associates is one of the largest brokerages in the nation.