Yesterday, Sergio Leal wrote an excellent blog on the perils of being underinsured. This post follows-up by discussing a little known provision in most insurance policies calling for stiff penalties to be assessed against the policyholder that fails to have sufficient limits to replace the property in the event of a covered loss: the coinsurance clause.

In addition to the problems articulated by Sergio, many homeowners have also been forced to deal with their policy’s “coinsurance clause” which limits replacement cost coverage in the event the insured underinsures the property. In effect, recovery is reduced in proportion to the value that was uninsured.

As one court explains:

Coinsurance means a relative division of the risk between insured and insurer and such clauses are "designed to compel the insured, either as self-insurer or otherwise, to carry insurance on the risk…."

"The effect of a coinsurance clause is to reduce the liability of an insurer in terms of the percentage of coverage which the clause requires the insured to maintain. That is to say, coinsurance clauses in substance require the insured to maintain insurance on the property covered by the policy in a certain amount and stipulate that upon his failure to do so, the insured shall become a coinsurer and bear his proportionate part of the loss on the deficit." [Citations omitted]1

Most policies have a coinsurance provision stating that if the covered property is not insured up to at least 80% (sometimes 90%) of its replacement cost, the policyholder may receive a reduced loss settlement. To explain coinsurance on a practical level, let us look at the following example. Assume that property valued at $100,000 is insured for only $40,000 and a loss of $40,000 occurs. If the policy had no coinsurance clause, the policyholder would receive $40,000 from the insurer. However, using the same figures and taking into account the usual 80% coinsurance clause, the policyholder would receive only $20,000 on the claim. Why is that? It’s because of the stiff coinsurance penalty assessed by the insurer. In our example, because the policyholder carried only one-half ($40,000) of the 80% ($80,000) insurance required by the coinsurance clause, the policyholder would receive only one-half ($20,000) of the $40,000 loss. Then, to add insult to injury, the insurer would still apply the policy’s deductible to the loss, further lessening the insured’s claim payment.

The lesson is, insure to full value. Make sure your policy limits are high enough to protect your property not only against the risk of loss, but also against application of the coinsurance clause.

1 Los Angeles Mut. Ins. Co. v. Cawog (1973) 30 Cal.App.3d 378, 385.