Understanding the Purpose of Coinsurance
In commercial property insurance, the coinsurance clause is a requirement that the policyholder must carry a limit of insurance equal to a specific percentage of the property's value—usually 80%, 90%, or 100%. The primary purpose is to encourage policyholders to insure their property to value. Since most property losses are partial rather than total, many business owners might be tempted to buy only enough insurance to cover a small fire. To ensure equitable premiums for all, insurers use the coinsurance formula to penalize those who underinsure.
Understanding this math is essential for passing the complete Commercial exam guide, as calculation questions are a staple of the Property & Casualty licensing exam. If you haven't yet, you should also practice these concepts with our practice Commercial questions.
Key Components of the Calculation
The 'Did Over Should' Formula
The formula most often taught for the commercial insurance exam is the "Did Over Should" method. This determines what portion of a loss the insurance company will pay if the policyholder failed to meet the coinsurance requirement at the time of the loss.
The standard formula is written as:
- (Amount of Insurance Carried / Amount of Insurance Required) x Amount of Loss = Claim Payment
Once you calculate the payment based on the ratio, you must always remember to subtract the deductible from the final result. The insurance company will never pay more than the limit of insurance carried, regardless of the formula's outcome.
Compliance vs. Non-Compliance
| Feature | Scenario Feature | Adequate Coverage | Underinsured (Penalty) |
|---|---|---|---|
| Limit Carried | $800,000 | $400,000 | |
| Property Value (80% Coins) | $1,000,000 | $1,000,000 | |
| Requirement Met? | Yes (100%) | No (50%) | |
| Loss Payment (of $100k) | $100,000 | $50,000 |
Exam Tip: The Order of Operations
On the exam, watch out for the deductible. Many students subtract the deductible from the loss before applying the coinsurance ratio. This is incorrect. Apply the ratio to the loss first, then subtract the deductible. If the policyholder met the coinsurance requirement, simply subtract the deductible from the loss (up to the policy limit).
Step-by-Step Calculation Walkthrough
Let's look at a typical exam problem: A building is valued at $500,000. The policy contains an 80% coinsurance clause. The owner carries $300,000 of insurance. A fire causes $100,000 in damage. The deductible is $1,000. How much will the insurer pay?
- Step 1: Calculate the 'Should.' Multiply the property value by the coinsurance percentage ($500,000 x 0.80 = $400,000). The owner should have carried $400,000.
- Step 2: Determine the Ratio. Divide the 'Did' by the 'Should' ($300,000 / $400,000 = 0.75). The owner is only covering 75% of their requirement.
- Step 3: Apply the Ratio to the Loss. Multiply the loss by the ratio ($100,000 x 0.75 = $75,000).
- Step 4: Subtract the Deductible. ($75,000 - $1,000 = $74,000).
The final answer is $74,000. Without the coinsurance penalty, the owner would have received $99,000 ($100,000 - $1,000). The penalty for underinsuring cost the owner $25,000.
Frequently Asked Questions
In the event of a total loss (where the loss equals or exceeds the limit of insurance), the coinsurance formula is generally not used. The insurer will simply pay the limit of insurance stated in the policy. The penalty is effectively the fact that the owner didn't have enough coverage to replace the building.
Coinsurance is calculated based on the value of the property at the time of the loss. If a building's value increases due to inflation or renovations but the insurance limit remains the same, the policyholder could unintentionally trigger a coinsurance penalty.
For the purposes of most state insurance exams, the deductible is applied after the coinsurance ratio has been applied to the loss. Applying it before will result in an incorrect answer choice that is often placed there as a distractor.
Agreed Value is an optional coverage that suspends the coinsurance clause. The insurer and insured agree on a value at the beginning of the policy year, and as long as that limit is carried, no coinsurance penalty will apply.