If you're in the market for property insurance coverage, you've probably come across the co-insurance clause that is included in most property insurance policies. Even if you think you understand it perfectly, it's worth going over the basics to make sure you know all the ins and outs of exactly how co-insurance works.
The truth is, co-insurance is one of the most misunderstood and confusing concepts in insurance—and insurance as a topic is not always simple to navigate in general. Co-insurance is a fundamental principle of property insurance included in home insurance and business insurance policies, so understanding how it works is the key to avoiding costly mistakes. In this article, we'll explain exactly what co-insurance is and how it's calculated, as well as answer a few common questions to help you ensure you have the right coverage limits for your insurance needs. We want you to know precisely what to expect when the time comes to file a claim.
Co-insurance is an agreement between you and the insurer that is providing you with property coverage whereby you agree to maintain coverage up to a stated percentage of the value of the property you wish to insure (usually 80% or 90%). It's very important to understand that the building must be insured with the required amount of insurance. As a result of this promise, a significant concession in the rate is given.
Should a loss occur, consideration is then given to the amount of insurance carried compared to actual cash values or replacement value of the insured property prior to a loss. If the amount of insurance is within the agreed co-insurance percentage requirement, the loss is paid in full, up to the policy limits. If, however, the amount of insurance you carry is below the agreed percentage, you and the insurance provider then share the loss.
It is important that the coverage limits on your commercial, rental or home properties are adequate to protect you fully in the event of a loss.
When you're trying to understand exactly how co-insurance works, it can be helpful to take a look at a couple of formulas that express how it's calculated.
The co-insurance formula is:
(Coverage Limit Purchased) × (Amount of Loss) = (Insurance Payout) ÷ (Required Coverage Limit)
Here's another way to write the same formula:
(Coverage Limit Purchased) ÷ (Required Coverage Limit) × (Amount of Loss) = (Insurance Payout)
In other words, the amount of insurance purchased is divided by the amount required and multiplied by the amount of the loss to find the amount of the insurance claim the policyholder can receive.
A commercial retail building has a value of $1,000,000, and the business owner chooses to insure it for $700,000, even though the co-insurance clause requires coverage that matches 90% of the replacement cost of the property. A flood occurs, which is covered by the commercial property insurance policy, and the property sustains $400,000 in damage. At first, the business owner assumes the entire cost of restoring the damage will be covered by their insurance because the total amount of the claim is well below the coverage limit of $700,000 they purchased.
However, because $700,000 is 77.78% of the co-insurance coverage requirement of $900,000, they didn't meet their co-insurance requirement and are underinsured, meaning the claim payout will be reduced by the percentage that the risk was underinsured. As a result, the claim is subject to a coinsurance penalty business owner is only eligible to receive 77.78% of the claim amount, or in this case, about $311,111, and is required to pay the deductible of $88,889 out-of-pocket to cover the cost of restoring the flood damage.
Here's the above example expressed as a formula:
$700,000 ÷ $900,000 × $400,000 = $311,111
In this example, $700,000 is the coverage limit the policyholder purchased. $900,000 is 90% of the building's replacement cost value. $400,000 is the amount of the loss, and $311,111 is the amount of compensation they are eligible to receive.
A homeowner purchases a new house, and the replacement value is $600,000. This is not the amount the property owner paid to buy the house, as real estate valuations consider factors that are irrelevant to the replacement value of the building. The homeowner has a co-insurance clause that requires 80% coverage, and they purchase home insurance with a $500,000 coverage limit. Shortly afterward, a fire destroys the house and it needs to be rebuilt from the ground up for a total cost of $600,000. Because 80% of $600,000 is $480,000, the homeowner actually has slightly more coverage than is required by their co-insurance clause. As a result, the entire claim amount of $600,000 is paid by the insurance company.
Here's the above example expressed as a formula:
$500,000 ÷ $480,000 × $600,000 = $625,000
In this example, $500,000 is the coverage limit purchased by the homeowner. $480,000 is 80% of the house's replacement value. $600,000 is the amount of the loss, and $625,000 is the amount of insurance compensation they are eligible to receive.
This is a key answer to understand because it's exactly where a lot of Ontario policyholders get confused and can end up not receiving the insurance compensation they were expecting after they file a claim. It's easy to see where the misunderstanding comes in—if the amount of your loss is less than the coverage limit, you may assume that the full amount of the claim will be paid regardless of the value of your property, but that's not the case with co-insurance.
In the commercial co-insurance example formula listed above, the policyholder files a claim for a $400,000 loss, which is well below the $700,000 coverage limit on their policy. However, because the total value of the building is $1,000,000, the $700,000 coverage limit falls short of the 80% coverage limit required by the commercial co-insurance clause since 90% of $1,000,000 is $900,000. $700,000 divided by $900,000 is 0.77777, meaning the policyholder only has 77.78% of the coverage limit amount they should have. The amount that the policyholder is underinsured is the amount by which their claim will be reduced. As a result, they are only eligible to receive an insurance payout of 77.78% of the amount of the claim, or in this case, $311,111—regardless of the fact that the amount of the loss is less than the coverage limit they purchased.
Insurance companies do not require an appraisal to determine the value of a building for the purposes of co-insurance. Instead, with the brokers assistance, a building valuation calculator can be used to determine the replacement cost. Building owners may want to obtain a professional appraisal to determine a more accurate cost of rebuilding to ensure their coverage limits are adequate to meet the co-insurance requirement of their policy. It is generally in the policyholder's best interests to have an appraisal done to confirm the value of the building because it's the only way to rest assured that you do have adequate coverage in place and you will be able to receive the full value of your claim should you experience a loss.
Your Morison Insurance broker has tools at their disposal to calculate an approximate estimated value for your property, but it's crucial to keep in mind that it's only an approximate estimate, and there may be factors at play that your broker doesn't know about and therefore can't account for. That's why it's much better to have a professional contractor evaluate the building and give you an estimate for the value of the building based on how much it would cost to rebuild if it was destroyed.
You may think you know the value of the building, but that's not necessarily the case. It's important to understand that the price you paid when you purchased the property is not necessarily the actual value for insurance purposes—in fact, it's typically not even close, and there are some good reasons for that.
Real estate value is calculated based on a wide range of factors that include location, land value and comparables, meaning how much similar buildings nearby have recently sold for. Location, for example, is an extremely important consideration in a real estate valuation because, as we all know, a building in a highly desirable location will sell for a much higher price than the exact same building in an undesirable location.
But value for the purposes of insurance coverage isn't concerned with the same factors. Instead, it's a reflection of how much it would cost to rebuild the building if it was severely damaged or completely destroyed. For example, suppose the worst happens and a fire tears through the building, burning it down to the ground. The cost of rebuilding it as it was before would be based on the cost of the building materials, contractor labour and other similar factors. The location, land value and comparables wouldn't matter in the slightest to the valuation, because the land is still there—it's the building that needs to be replaced.
That's why real estate value and valuations for the purpose of insurance coverage are almost always very different amounts, and you can't simply use the purchase value of the property to determine the value of the building when you are in the process of deciding which coverage limit to go with for your co-insurance policy.
It's safe to say that the cost of replacing a building will always change somewhat over time. Inflation has a big effect on the cost of materials and contractor labour, so the cost of rebuilding today is going to be quite different in 10 years. You may also invest in renovations over the years that can increase the value of the building. Therefore, it's really important that when your insurance renewal rolls around, you take the time to consider anything you may have done to enhance the value of the building and let your Morison Insurance broker know so they can help you adjust your coverage limits.
It's also recommended that policyholders consider having an appraisal re-done every five years. Doing so will give you the peace of mind that comes with knowing you have adequate insurance coverage limits and your co-insurance clause won't reduce your claim amount should you experience a loss.
While the examples above dealt solely with the building replacement cost for the sake of keeping the explanation simple, it's crucial to know that co-insurance clauses can be applied to other types of property coverage limits such as the contents limit, equipment limit, stock limit, business income limit and or rental income limit. This means that the coverage limits you purchase for the contents of your home, for example, can also be subject to a co-insurance clause.
These coverages actually do fall under the broad category of property insurance, but they don't pertain specifically to the building. Contents coverage, for example, is a type of property insurance that applies to the contents of the insured property that aren't a part of the building itself, such as furniture, electronics, and pretty much all the belongings or items on the property. Co-insurance clauses typically apply to all the property-related coverages that are a part of your home or business insurance policy.
If you are insuring a rental property that you own, for example, you'll need property insurance coverage for the building itself. However, you also need coverage for the items you own that are not part of the building itself, such as appliances, furniture, and other types of equipment. Additionally, you need landlord insurance coverages such as loss of rental income coverage and coverage for structures such as outbuildings, and all of that can be subjected to a co-insurance clause. If you're not sure exactly where co-insurance applies to your policies or how much it is, give us a call to speak with your courteous, knowledgeable Morison Insurance broker before filing a property damage claim. We'll be happy to review your insurance policy documents and get you the information you need to ensure your co-insurance is working for you, not against you.
Commercial insurance policies typically have co-insurance clauses, but home insurance policies and other types of personal insurance policies can also have co-insurance clauses. When you work with an experienced broker such as the professionals at Morison Insurance, you get the benefit of having all clauses and conditions explained clearly to you so you know exactly what to expect from your insurance coverage. If you have questions about your coverage, or you're looking for a certain type of insurance, give us a call today to speak with a qualified broker. We're happy to answer any questions you may have and offer you all the information you need to be fully informed about your insurance coverage and options, including co-insurance clauses—commercial or otherwise.
Are you puzzling over the meaning of a co-insurance clause in your insurance policy, or do you have questions about co-insurance and how to ensure you have the right amount of coverage to avoid a co-insurance penalty on your claim? Your friendly broker has the answers you're seeking!
If you have any questions or concerns about business insurance, home insurance, coverage limits, or other commercial or personal insurance matters, contact us at Morison Insurance. We’re here to help!
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