Most Dangerous Concept in Insurance, Co-Insurance

One of the most dangerous concepts in insurance is "co-insurance". I say dangerous because if you don't understand it, you can get burned by your own uninformed decisions.

Long ago, when insurance came to be, an interesting "battle" took place...

Insurance companies determined that by taking a little bit of money (premium) from lots of people, they could afford to pay for huge losses of only a few of those people. Based on expected losses they decided how much premium to charge. And an assumption they made was that everybody would insure their property fully.

Bad assumption! Policyholders quickly realized that most losses are small - rarely a total loss. So, instead of insuring their $100,000 building for $100,000, they insured it for less - risking that they wouldn't suffer a total loss. This wrecked the insurance companies' ability to pay losses and be profitable, too.

So, the insurance companies invented "co-insurance" - which basically means if you don't insure the full value of your property, you're going to share in the partial losses.

For example (simplified for illustrative purposes), if you have a building worth $100,000 and insure it for $80,000, you've insured 80% of value. If there's a total loss, you only get $80,000 because that's the coverage limit you chose. That's NOT co-insurance. That's coverage limits.

However, that's still a pretty compelling reason to insure to full value.

Now most policies require you to insure at least 80% of value to avoid a "co-insurance penalty" at the time of loss. (But, remember, your policy will never pay more than the limits of coverage. So, if you insure 80% of value and have a total loss, you're only going to get 80% of the loss from the insurance company - your policy limits.)

Wait! There's one last landmine here...

To determine if a co-insurance penalty will apply, the value of your property will be determined at the time of loss - NOT what it was worth when you bought it, NOT what it was worth when you bought your policy, and NOT what you say its worth.

The insurance company will determine the value of your property at the time the loss occurred. Why is this important?

Let's say you paid $100,000 for your building 5 years ago, and insured it for $100,000 thinking you were fully insured, no chance for a co-insurance penalty. And let's say the building is worth $150,000 today. Let's also assume for illustrative purposes, that the replacement cost of this building is now $200,000 due to inflation, but you never increased your insurance.

Now there's a $10,000 partial loss, the insurance company values the replacement cost of your building at $200,000 and says, "A co-insurance penalty applies, because you insured a value of $100,000 (100% of the old replacement value) instead of $160,000 (which is 80% of the building's current replacement value of $200,000.

Co-insurance comes into play on partial losses. In this example, if you have a partial loss, of say $10,000, the insurance company will only pay $6,250 or 62.5% of the loss less your deductible, rather than $10,000 less the deductible. The adjuster begins his calculations by determining the replacement cost at the time of loss, $200,000 in this case. Since you had an 80% co-insurance clause you had to insure a minimum of $160,000. Since you only insured $100,000, the adjuster now takes $100,000 (amount of insurance) divided by $160,000 (amount of insurance required) and then multiplies it by $10,000 (the amount of the loss). Then, he apples the deductible. That's co-insurance.

What a nasty surprise!

There are a number of tools to help prevent this. "Inflation Guard" protection and annual reviews are two good ones. The most important thing is for you to have a basic understanding of your exposure.

Ultimately, your insurance decisions are yours. Be an educated consumer and make sure you get what you want. Give me a call if you want to discuss any of your coverage limits or get more information.

Most Dangerous Concept in Insurance, Co-Insurance

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