Commercial property policies (CPP’s) and homeowners’ forms widely differ in the application of the coinsurance condition. The coinsurance calculation is the same, but little else applies to both coverage types.
Below is a comparison of the two coverages. This two-part series ends with an executive summary of sorts of the important points and ideas to remember regarding coinsurance.
What is the “Total Insurable Value” (TIV)
Property has many different values: replacement cost; actual cash value; market value; tax value; and even accounting value among others. To this point, the meaning of total insurable value related to the coinsurance calculation has not been defined.
Replacement cost and actual cash value (ACV) are the only two property values to be considered when developing and choosing the limits of property coverage and applying the coinsurance penalty. None of the other named property “values” relate specifically to insurance (“market value” does play a part in ordinance or law losses and flood losses, but should not be considered otherwise). A detailed series on property values as they relate to insurance is available here.
Homeowners’ policies value most real property (Coverages “A” and “B”) at replacement cost (unless altered by the HO 04 81 ACV endorsement). So for Coverages “A” and “B,” TIV is based on the property’s replacement cost at the time of the loss. If the amount of coverage does not equal or exceed the replacement cost TIV multiplied by the coinsurance percentage, the insured will not be fully covered for partial losses.
Commercial property policies (CPP’s) in contrast may use either ACV or replacement cost depending on the options chosen by the insured when the policy is first placed. Unaltered CPP’s value real and personal property based on its ACV; the insured must specifically request the replacement cost settlement option. The basics of the coinsurance calculation are the same regardless of the valuation method chosen; the difference is the values used to calculate the coinsurance penalty. If the insured alters the CPP by choosing replacement cost, it must confirm that all the values are correct and current to avoid application of the coinsurance penalty.
Many published discussions of coinsurance speak of the up and down values of commercial and residential structures and the need to stay on top of values to assure that the coinsurance condition is satisfied. Sadly, these discussions are confusing replacement cost and actual cash value with market value. Market values (what a willing buyer will pay a willing seller) do fluctuate, but replacement cost and ACV don’t see wide variations from year to year. An exception to this statement occurs in the aftermath of a catastrophe when the cost to rebuild a structure steeply increases because demand for labor and materials far surpasses the supply.
What Property is Subject to Coinsurance?
Homeowners’ and commercial property policies also differ in regards to the types of property to which the coinsurance condition applies. The Insurance Services Office’s (ISO) homeowners’ policy limits the applicability of coinsurance to only real property losses – Coverages “A” and “B.” This is even true of ISO’s dwelling property program. However, coinsurance applies to all “covered property” in ISO’s commercial property policy; this includes both real and business personal property.
Condition “C” – Loss Settlement in the HO-3 states that buildings covered under Coverage “A” and “B” are valued at replacement cost (as discussed above), subject to an 80 percent insurance-to-value (ITV) requirement. The policy goes on to describe the coinsurance calculation as detailed earlier; but the homeowners’ policy does not give a coinsurance calculation example.
In contrast, the additional condition “coinsurance” (“F.1.”) in ISO’s commercial property policy states that the coinsurance condition applies to real and personal property as follows:
“We will not pay the full amount of any loss if the value of Covered Property at the time of loss times the Coinsurance percentage shown for it in the Declarations is greater than the Limit of Insurance for the property.”
“Covered property” is defined at the outset of the CPP as building (“A.1.a.”), business personal property (“A.1.b.”) and personal property of others (“A.1.c.”). The coinsurance condition applies to each of these classes of covered property. The interesting part is that the insured could be adequately insured for one class of property yet underinsured on another.
Note also the difference in the location of the specified coinsurance percentage. The homeowners’ policy species 80 percent in the coverage form itself (but it can be altered by the HO 04 56 Special Loss Settlement endorsement). The CPP refers the reader to the declaration page to find the applicable coinsurance percentage. Eighty percent is the traditional amount, but it is not the only percentage available for commercial property, as is discussed in an upcoming section.
Differences in Appling Coinsurance (Not Always a Penalty)
Another difference between the coinsurance conditions contained in the commercial property policy and homeowners’ form is in the application of coinsurance as a penalty related to the final loss payment. CPP provisions penalize violations of coinsurance provisions; but the homeowners’ form indemnifies the insured even when the coinsurance requirement test is failed.
Once determined that the insured did not carry enough protection to satisfy the coinsurance provision, the CPP mandates that the coinsurance penalty calculation be completed (as detailed in the prior post). Once complete, the insured gets paid the LESSER of: 1) the limits of insurance; or 2) the results of the coinsurance calculation.
ISO’s homeowners’ policy does not necessarily apply the coinsurance calculation as a punishment; indemnification is still preserved in the policy wording. While the opportunity for the structure to be covered at replacement cost is deleted, the policy still states that if the insured fails to maintain adequate insurance, the insured will be paid the GREATER of: 1) the damaged property’s actual cash value; or 2) the results of the coinsurance calculation (both subject to the limits of protection purchased).
Attached is a claim scenario that demonstrates how this homeowners’ provision might apply to a particular loss. Notice in this particular scenario that the insured receives the ACV. Had the home been eight years old rather than five, the insured would likely be paid the result of the coinsurance calculation.
The commercial property policy allows the insured the option to use 80%, 90% or 100% coinsurance. As the coinsurance percentage increases, the property rate (or loss cost) decreases. But should 100 percent coinsurance be used?
From an errors and omissions perspective, probably not; using 100 percent coinsurance leaves no room for an incorrect calculation which requires the insured to always have 100 percent of the value in force. Even attaching the inflation guard endorsement may not give the insured adequate coverage at the time of the loss.
Commercial property policy insureds also have the opportunity to write all property coverage under a blanket limit of protection. Blanket limit policies are the preferred method when the insured is trying to avoid undervaluing a particular class of property or a particular property location (especially if there are several properties or contents moving among several buildings or locations). However, use of a blanket limit requires the minimum coinsurance percentage be increased to 90 percent.
One approach CPP insureds can employ to avoid the application of coinsurance is “agreed value.” As the name suggests, the agreed value is the value the insured and the underwriter agree the property is worth. Attaching the agreed value endorsement suspends the coinsurance provision for one year. At the end of the year, a new schedule must be submitted and a new agreement reached.
While the agreed value provision is in force, all losses are paid in full up to the limit of coverage, provided the insured purchases coverage equal to the agreed value. If, for some strange reason, the insured does not purchase the agreed value amount, all losses are subject to a form of a coinsurance penalty. But this penalty is based on failure to live up to a separate contract rather than a failure to buy enough coverage.
How Much Coverage
Coinsurance provisions and penalties should not be the deciding factor in regards to coverage limits. Forgetting MPL’s, PML’s and statistical loss chances, the insured should purchase coverage equal to 100 percent of the property’s total insurable value (TIV), based on whether ACV or replacement cost is the valuation method. Buying coverage at this level accomplishes two goals: 1) it avoids the possible application of coinsurance; and 2) it assures that the insured is fully covered for a total loss.
But, as stated above, even though the property is valued at 100 percent of its TIV, do not increase the commercial client’s coinsurance to 100 percent (even though there is a slight premium break). Use 90 percent to avoid most miscalculation problems and allow some room for an unexpected increase in replacement cost.
Important Coinsurance Conditions and Ideas
- Coinsurance “encourages” insureds to carry relatively high limits of coverage.
- Coinsurance applies to only partial losses. Insureds don’t get more than the limits purchased.
- Coinsurance is calculated based on the values at the time of the loss.
- The simplified coinsurance formula is: (Did / Should) x Loss – Deductible = Payment.
- Commercial property policies and homeowners’ policies differ on the application of coinsurance.
- Purchase blanket limits of protection when possible (the coinsurance requirement is increased to 90 percent).
- Use agreed value (remember, the coinsurance requirement is waived, but the insured must purchase the agreed amount).
- Blanket Agreed Value – the agent’s friend.
- Insure at 100 percent ITV, but don’t use 100 percent coinsurance.