How the coinsurance penalty works

Property coinsurance is one of the few places on a P&C licensing exam where you have to do real arithmetic, and it's a favorite scenario question. It's also a real-world surprise for business owners who find out after a loss that their claim was cut because the building was underinsured. The formula is short. The traps are in the details.

Note that property coinsurance is not the same thing as health insurance coinsurance. In health insurance, coinsurance is your percentage share of each bill. In property insurance, it's a clause requiring you to carry a minimum amount of insurance relative to the property's value.

What the coinsurance clause says

A property policy with an 80% coinsurance clause requires you to insure the property for at least 80% of its value at the time of the loss. Carry that much and partial losses are paid in full, up to the limit, minus the deductible. Carry less and the insurer pays only a proportion of the loss.

Why have it? Most property losses are partial. Without the clause, an owner could insure a $1 million building for $200,000, pay a small premium, and still collect in full on most fires. The clause makes underinsuring cost you at claim time.

The formula

(Did / Should) x Loss - Deductible = Payment

• Did: the amount of insurance you actually carried.
• Should: the coinsurance percentage x the property's value at the time of the loss.
• The payment can never exceed the policy limit.

If Did is equal to or greater than Should, the ratio is capped at 1 and there's no penalty.

Example 1: underinsured, partial loss

A building is worth $500,000 at the time of the loss. The policy has an 80% coinsurance clause, a $300,000 limit and a $1,000 deductible. A fire causes $100,000 of damage.

• Should = 80% x $500,000 = $400,000
• Did / Should = $300,000 / $400,000 = 0.75
• 0.75 x $100,000 = $75,000
• $75,000 - $1,000 = $74,000

Without the penalty, the insurer would have paid $99,000. The owner absorbs $25,000 of the loss plus the deductible.

Example 2: same building, properly insured

Same building, same fire, but the owner carried $400,000.

• Did / Should = $400,000 / $400,000 = 1
• 1 x $100,000 - $1,000 = $99,000

Meeting the requirement exactly is enough. You don't need to insure to 100% of value to avoid the penalty under an 80% clause.

Example 3: a big loss runs into the limit

Back to the $300,000 policy, but now the loss is $450,000.

• 0.75 x $450,000 = $337,500
• $337,500 - $1,000 = $336,500
• That's more than the $300,000 limit, so the insurer pays $300,000.

The limit always caps the payment, whatever the formula says.

Example 4: the classic exam version

A building is insured for 70% of its value under an 80% clause and suffers a $50,000 loss. Ignore the deductible. What does the insurer pay?

You don't need the dollar value of the building here, because the ratio is all percentages: Did / Should = 70% / 80% = 0.875. So 0.875 x $50,000 = $43,750.

The traps

• Value is measured at the time of the loss, not when you bought the policy. A building that was adequately insured three years ago can fall short after construction costs rise. That's how many owners end up penalized without ever deciding to underinsure.
• Use the coinsurance percentage to find Should, not the full value. A common wrong answer divides Did by the full $500,000 value in Example 1, giving 0.6 instead of 0.75.
• Apply the ratio to the loss, then subtract the deductible. Doing it in the other order gives a slightly different answer, and exam questions are written to catch it.
• Check the limit last. The formula can produce a number above the limit on a large loss.

Homeowners policies use a related idea: the replacement cost loss settlement condition typically asks you to insure the dwelling to at least 80% of its replacement cost to get losses paid on a replacement cost basis.

Practice it until it's automatic

The coinsurance penalty calculator runs the formula for any value, clause percentage, limit, deductible and loss, which makes it a quick way to check your own practice answers. For the rest of the exam, what's on the Texas P&C exam covers the outline, and how to study for the Texas general lines exam covers the plan. Coinsurance comes up in the property basics, homeowners and commercial property units of Encodr's Texas Property and Casualty course.