DEFINITION
What Is the Coinsurance Formula?
The coinsurance formula is the homeowners insurance formula that determines the amount of reimbursement that a homeowner will receive from a claim. The coinsurance formula becomes effective when a homeowner fails to maintain coverage of at least 80% of the home's replacement value.
Those who file a claim in this situation will only receive partial reimbursement according to the formula. Financial consequences include not meeting the required coverage, such as becoming a "co-insurer" and sharing losses. It's critical to the insurance process that insurers require fair premiums and policyholders insure the property's value appropriately.
KEY TAKEAWAYS
- The coinsurance formula determines the reimbursement from a homeowner's insurance claim when coverage is below the required amount.
- If coverage is less than 80% of the property's value, the homeowner shares the financial risk with the insurer.
- Homeowners can avoid penalties by insuring their property to at least 80% of its replacement value.
- Coinsurance ensures policyholders adequately cover their property, aligning insurance premiums with risk.
- Adjust insurance coverage regularly to meet any changes in property value and avoid coinsurance penalties.
Understanding How the Coinsurance Formula Operates
Coinsurance is a clause found in property insurance contracts, like homeowners insurance. The clause ensures that policyholders insure their property at a suitable value, providing the insurer with a fair premium for the risk. If you have a mortgage, your lender will likely require a minimum amount of coverage.
Coinsurance is typically shown as a percentage. Most coinsurance clauses require policyholders to insure 80%, 90%, or 100% of a property's actual value. For instance, a building valued at $1,000,000 replacement value with a coinsurance clause of 90% must be insured for no less than $900,000. The same building with an 80% coinsurance clause must be insured for no less than $800,000.
The coinsurance formula is relatively straightforward. Start by dividing the actual coverage amount by what should have been carried (80% of the replacement value). Then, multiply that result by the loss amount to find the reimbursement.1
IMPORTANT
If a property owner insures a property for less than the amount required by the coinsurance clause, they become a "co-insurer" and will share the loss with the insurance company according to the coinsurance formula.
Examples of the Coinsurance Formula
Here are two examples that demonstrate how the coinsurance clause works.
Example 1: Inadequate Amount of Coverage
Building Value: $1,000,000
Coinsurance Requirement: 80%
Required Amount of Insurance: $800,000
Actual Amount of Insurance: $600,000
Amount of Loss or Cost of Repairs: $300,000
The coinsurance formula is:
[(Actual amount of insurance / Required amount of insurance) X amount of loss] - deductible = Amount of claim paid by the insurer
Based on the amounts above, the formula produces the following:
- ($600,000 actual coverage / $800,000 required coverage) = 0.75 or 75% of the required minimum coverage
- 0.75 X $300,000 in damages = $225,000 paid by the insurer for the claim
The insurance company will pay $225,000 of the claim despite $300,000 worth of damage. The owner absorbs a $75,000 coinsurance penalty since they did not buy enough coverage. Therefore, the owner pays out of pocket for 25% of the loss.
Even though the owner had more than enough coverage to cover the claim amount—$600,000 in coverage for a $300,000 claim—the owner was underinsured. The owner had only 75% of the required minimum coverage of $800,000. As a result, the insurer only paid 75% of the claim amount.
Example 2: Adequate Amount of Coverage
If the building had been insured to the amount required by the coinsurance clause (in this case, 80%), the coinsurance calculation would look like this:
Building Value: $1,000,000
Coinsurance Requirement: 80%
Required Amount of Insurance: $800,000
Actual Amount of Insurance: $800,000
Amount of Loss or Cost of Repairs: $300,000
Here's the formula again:
[(Actual amount of insurance / Required amount of insurance) X amount of loss] - deductible = Amount of claim paid by the insurer
And here's the calculation:
- ($800,000 actual coverage / $800,000 required coverage) = 1; required coverage satisfied
- 1 X $300,000 in losses = $300,000 paid by the insurer
In the second example, the owner met the coinsurance requirement and did not need to pay anything out of pocket. In other words, the insurer will pay the total amount of the $300,000 claim without penalty to the owner.2
Importance of Monitoring Your Insurance Coverage
These examples show why it's crucial to have enough insurance to meet the insurer's required percentage of property value. If the property value rose 20% to $1,250,000, then $800,000 in coverage would be inadequate, as it's only 64% of the value, not the required 80%.
It's also important to know how much of a deductible you are responsible for in your policy. The examples above assumed no deductible. If there was a deductible, the deductible amount would reduce the insurance company's claim payment, and the owner would be responsible for paying that amount out of pocket. Coinsurance clauses are also found in business interruption policies. These clauses ensure that policyholders insure their revenue stream to an appropriate value.
What Does 80% Coinsurance Mean for Homeowners?
Many insurance companies require property owners to buy a minimum amount of coverage. Typically, insurers require at least 80% of the property's replacement value in coverage. If the homeowner buys an inadequate amount of insurance, the insurer may not cover 100% of the claim amount.
How Do You Calculate Coinsurance on a Property?
To calculate the coinsurance penalty, divide the amount of current insurance coverage by the required insurance amount and multiply that result by the loss or cost to repair the property. The required insurance amount should be stated in your policy and is often expressed as a percentage of the property value, such as 80%.
What Coverage Limit Should I Buy for My Home?
If you buy a home, check with your mortgage lender and the required homeowners insurance coverage. Many insurers require at least 80% of the replacement value of the property, but some policies require 90% or 100%.3
The Bottom Line
The coinsurance formula determines the amount of reimbursement that a homeowner or property owner will receive from a claim. Homeowners are required to have a minimum amount of coverage when they buy a homeowners insurance policy, which is typically 80% of the property's replacement value. The coinsurance formula is applied when a property owner fails to maintain the minimum coverage. As a result, the owner will be responsible for a percentage of the loss out of pocket.
Homeowners should regularly review and update their coverage to ensure compliance with the coinsurance requirements, especially in light of potential property value increases. Understanding coinsurance requirements aids in managing insurance claims effectively and protecting financial assets.