When a small strip mall in northern Alabama was damaged by a tornado, the owner promptly submitted a claim. It wasn’t a total loss – the tornado did an estimated $500,000 damage to one side of the structure, which was worth about $3 million.
The policy hadn’t been updated in some time. But the limit of insurance was $2 million – well over the damage estimate. The owner was confident he’d get a quick settlement for the full amount of the damage, minus the $10,000 deductible.
But after the adjustor’s visit, the owner got a nasty surprise: Instead of the $490,000 settlement he expected, the insurance company came back with a settlement for significantly less: $406,500, to be exact.
The owner went to his attorney, who had experience in property insurance claims law of this type. He took a look at the policy, did some quick math, and said “Yep! The settlement is correct, according to this contract. In fact, this is pretty standard.”
What happened?
The attorney explained how the insurance company arrived at the settlement figure: The building was worth $3 million, but was only insured for $2 million and carried an 80% coinsurance clause, said the lawyer, who told them “it’s how co-insurance works in commercial property insurance. If you are underinsured for a total loss, you’re underinsured for partial losses, too.”
The miscommunication
At issue was what insurance professionals call the “co-insurance penalty.” It’s well understood among insurance and risk management professionals, but it’s a common source of confusion among business owners and landlords – unless they have a great agent that explains how it works.
Commercial property coinsurance works differently than coinsurance in the more familiar health insurance contexts, where it is more commonly encountered in our everyday lives. In commercial property insurance, coinsurance is a penalty applied against the amount of the loss when the limit of coverage on the policy is less than a specific percentage (80 and 90 percent are common) of the value of the insured property, as of the date of the loss.
To avoid the coinsurance penalty, it’s important to fully value your property when you buy the policy, and also when you update your coverage.
Significantly undervaluing a property with the insurance carrier may save a few dollars in premiums in the short run – but could leave you dangerously underprotected in the event of a loss. Don’t get confused with the valuation method of replacement cost as the amount paid to you in the event of a loss is still subject to the limit and coinsurance. The replacement cost is simply that – the cost to replace the building with materials of like kind and quality. There are recognized valuation methodologies and calculators that can assist you in determining this value such as Marshall Swift, but you have to actually use that value as the limit on your policy in order for the coinsurance penalty to not apply.
Despite knowing what the true replacement cost is for their structure, some property owners still underinsure it. While this may save a few dollars in premium for now it would cost dearly in the event of a claim.
How dearly? Let’s go back to our mini-mall example:
At the time they bought the building, the building was only worth $2 million. The lender required they maintain at least $2 million in insurance, which theoretically covered them for the loan.
Which is all they cared about.
Meanwhile, the owners had made capital improvements to the property and construction costs in their area had escalated over a twenty year period causing the true replacement cost value of the building to increase to $3 million.
But the owners didn’t increase their insurance coverage to keep up with the replacement cost value of the property – and so their insurance fell below the 80 percent coinsurance requirement.
The building owners had been paying premiums for years, confident that they would be fully compensated for any losses in excess of their $10,000 deductible. And so they kept $10,000 in reserves for this purpose. But because they didn’t meet the 80 percent coinsurance requirement listed in the “declarations” section of their policy, their deductible wound up being a lot more than $10,000. Effectively, they had a deductible of $73,333!
To avoid getting a nasty surprise at claim time, it’s critical to take these steps up front:
- Take the time to have a full valuation done on your property. Understand the difference between insuring for replacement cost vs. market value. Our agents have access to sophisticated Marshall & Swift software that will enable them to quickly and easily run a calculation of the full replacement cost for your property, as appropriate.
- Double-check the coinsurance requirement. You’ll find in the “declarations” section of your insurance contract. In most cases it’s 80 or 90 percent. To avoid a coinsurance penalty in the event of a claim, you must have a limit of insurance on the policy that is at least equal to 80 percent (or whatever the coinsurance percentage) of the replacement cost value of your property at the time of the loss.
- Update your policy regularly. You’ll need to account for the following variables:
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- Changes in replacement or reconstruction cost. Note: A decline in market value does not necessarily translate to a decline in replacement or reconstruction cost. When dealing with property insurance, it is replacement and/or reconstruction costs that count.
- Depreciation/wear and tear/planned obsolescence
- Capital improvements and renovations
If the value of your property increases during the year, it could cause your policy limit of insurance to fall below the coinsurance requirement – potentially triggering a coinsurance penalty in the event of a claim.
- Keep your risk advisor informed. If you make improvements to the property, tell your risk advisor right away, so that your policy can be upgraded to include the value of the new improvements.
- Don’t fall for attempts to reduce premium by underinsuring the property. In the long run, nobody benefits.
- Consider including an agreed value endorsement. When properly employed, an agreed value provision waives the coinsurance penalty clause. Note that the agreed value needs to be updated annually, with the assent of both you and the insurance carrier.
- Discuss any possible coinsurance issues with your risk advisor. Not every property and casualty insurance agent fully understands co-insurance issues. HDB’s risk advisors are experts at them.
Occasionally, insurance agents compete for business by showing a “quote” based on very preliminary assumptions about the value of the property. Too often, competing agents show an unrealistically low premium in an attempt to get the customer to switch over. Competition is good! But this is where the unwary can be unwittingly lured into underinsuring their properties, and exposing themselves to the coinsurance penalty. Please call us at 800-239-5512 and one of our risk advisors will be happy to help you.
*This article is written for informational purposes only and should not be construed as providing legal advice.
