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Coinsurance Obligations

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We know the damage the real estate market nose dive has done to property values, but just because a home’s value has declined doesn’t mean it will cost any less to rebuild.

That important distinction is why it is imperative for an insured to maintain coverage for the total rebuild value of a home, rather than its market value. Failing to do so can mean trouble for brokers, agents, and clients alike.

Market values have declined almost across the board, to the point where home rebuild costs may actually exceed the actual value of the home. Seem strange? It is actually quite common. Too many people insure their homes for market value. In doing so, they’re setting themselves up for an unpleasant surprise when a claim arises.

What happens if an insured has inadequate insurance on his/her property? For one, the insurer will not only decline to pay the cost to fix the house, but also will likely penalize the insured for under-valuation. This is known as a coinsurance penalty. It is important to remember that in many cases, the insured declares the value of their home. So, realistically, the fault lies with the insured.

The coinsurance clause is designed to encourage the insured to purchase a sufficient amount of insurance. Failure to do so may result in a penalty at the time of loss. That penalty typically is proportional to the amount by which the property is under-insured. In property insurance, coinsurance requires the policyholder to carry insurance equal to a specified percentage of the value of property to receive full payment on a loss. If the percentage is not met, then a penalty is imposed on the insured by the insurance carrier. The most commonly used ratio is 80/20, meaning the insured must carry at least 80 percent of the replacement cost at the time of loss for their claim to be paid.

A coinsurance clause can be confusing. Let’s use an example to explain it more clearly: A home with a value of $350,000 and an 80 percent coinsurance clause must be insured for at least $280,000. Coverage of less than the required amount will result in the insurance company paying a reduced amount for a claim, even if the claim is less than the amount of coverage. Suppose the homeowner in this scenario carries $200,000 of coverage, $80,000 less than required by the coinsurance clause. A fire causing damage of $150,000 will result in an insurance reimbursement equal to the proportion of actual coverage compared to the required coverage times the amount of the claim. In this case, reimbursement is ($200,000/$280,000) x $150,000, or $107,142, less any deductible.

On top of the insured being under-insured, brokers and agents still have Errors & Omissions claims to deal with. E&O claims resulting from insureds that suffered coinsurance penalties are very common. It is vital that every agent in your agency not only understand the concept and the consequences, but also be able to effectively explain them to others.

Also be certain that your clients understand the difference between market value and rebuild cost. Just because something cost $850,000 does not mean it can be rebuilt with $850,000. When it comes down to it, the insured must make sure they maintain and understand their insurance policies and the broker or agent must also make sure their insured is informed and educated.

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