Chapter 5 Conditions and Limitations

• Library: The Commercial Property Insurance Policy Deskbook (ABA) (2018 Ed.)

CHAPTER 5 Conditions and Limitations

Coinsurance or Average Clauses

Almost every commercial property insurance policy contains a coinsurance provision that is—with regard to marine insurance—known as an "average" clause acts as an incentive to the insured to insure the property to value. It is not, like in health insurance, a self-insured retention or deductible where the insured pays a part of every claim.

The coinsurance condition was introduced as a standard clause by the Louisville Board of Fire Underwriters in 1885 for pork and tobacco risks. It was expanded to other property in 1890. However, individual insurer use of this condition dates back to at least 1877. Coinsurance clauses were created to incentivize the insured to purchase an adequate level of coverage, not to require the insured to pay a part of every claim.

Coinsurance is a contractual requirement that the insured carry agreed upon insurance-to-value, as specified by a percentage (usually 80 percent, 90 percent, or 100 percent) entry on the declarations page. If, at the time of loss, the limit of insurance is less than the value of the property times the coinsurance percentage, the insured will be designated as a coinsurer along with the insurance company when a loss occurs. Technically, an insured cannot be an insurer. The coinsurance provision compels, by a condition precedent, that the insured pay an easily calculated percentage of any loss incurred.

A coinsurance provision can be one of the most important provisions of the building and personal property coverage form. It is also the most often misunderstood, maligned, and breached provision in commercial insurance. Some insureds and adjusters believe, incorrectly, that if an 80 percent coinsurance clause appears in a policy, the insured can collect only 80 percent of a loss. This is totally wrong and may be the result of attempts to compare a similarly named provision in a health insurance policy.

Rather, the coinsurance agreement states that in return for a rate reduction, the insured agrees to carry insurance at an amount at least equal to an agreed percentage of the actual cash value or replacement value of the property. The coinsurance clause tells the insured that he or she must insure the property to the value agreed or share proportionately with the insurer the amount of the loss. If the insured fails to carry the agreed upon percentage of actual cash value or replacement value, the insured assumes a part of each loss in proportion to the difference between fact and the promise. Both parties benefit from this arrangement: the insured gets a reduced rate, and the insurer gets an assurance of adequate coverage and an appropriate premium.

How Coinsurance Is Calculated

Following are two abbreviated statements of loss that illustrate the operation of the coinsurance clause. In the first situation, there is sufficient insurance and in the second the insurance is insufficient.

The actual cash value of the property is $50,000. The coinsurance clause in the policy is 80 percent. The minimum insurance required is 80 percent of the actual cash value, or $40,000.

Situation 1

A loss occurs, amounting to $10,000. The insurance carried at the time of loss is $40,000.

The formula to remember in computing coinsurance is: insurance carried (IC) divided by insurance required (IR) times loss (L) equals the amount recovered (AR), or IC x L = AR IR.

The insurer pays based on this formula:

$40,000 (insurance carried) x 10,000 (amount of the loss) = $10,000 (claim payable)

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