Coinsurance is not a penalty. Coinsurance provisions are mechanisms to make commercial property insurance more affordable. What?
Coinsurance encourages commercial risks to insure to value. In turn, the average cost per $100 of insurance is dramatically reduced. To understand this concept, one needs to understand how property rates are developed.
As with any line of insurance, the driving factor behind property rates are driven by expected losses. As most of us know, most losses are smaller losses (less than $100,000). As building codes are requiring more and more buildings to be sprinklered, this is becoming truer and makes large property losses less likely. The fact is sprinklers reduce the potential loss by almost 85%. Property underwriters can verify the “probable maximum loss” on protected commercial structures is usually below 50% of the replacement cost of those structures.
Commercial property coverage is usually provided on a blended or average rate basis. By that I mean, clients pay the same rate per $100 of insurance for the bottom layers as they do for the upper layers. However, the marginal cost of each layer varies dramatically.
For example, assume the replacement cost for a building is $10,000,000 and the property insurer is charging a .10 rate per $100 for a premium of $10,000. Since most of the loss potential is within the bottom $5,000,000 of limit, the marginal cost of the bottom layer is significantly higher than the top $5,000,000 layer. The reality is the marginal loss cost (portion of the rate driven by expected losses) for the bottom $5,000,000 is over double the loss cost top $5,000,000. Therefore, the rate per $100 and premium for the bottom is more like .15 and $7,500, respectively. The rate and premium for the top $5,000,000 is .05 and $2,500, respectively.
Since the same rates are calculated and applied uniformly to the entire replacement cost, there needs to be a mechanism to assure insuring to value. That is where coinsurance clauses come in to play. They are the mechanism to assure the client insures to a certain level, so the rates charged are fair and equitable.
Insurance professionals need to understand the ideology behind premium development. In doing so, they can be better counselors for their clients by being adept at explaining the concepts to help insureds make better buying decisions.