On its surface, coinsurance sounds like a simple term where two parties might come together to jointly insure a risk. However, when used in the context of home insurance, coinsurance can be a costly mistake for homeowners. It is actually something of a penalty built into home insurance policies and other types of property policies whereby the insured might end up paying a part of the claim. The coinsurance penalty is triggered when the proper value of the asset being insured is not properly reported to the insurance company.
When insuring your home, you need to report to your insurance company the total replacement cost of your home and its contents. This amount is reflected on the home insurance policy as the limit of insurance and the most that can be paid to you in the event of damage or destruction. In many policies, if you do not report at least 80% of the total replacement cost, you will be charged a coinsurance penalty. For example, if you have a $1 million home that you only insured for $750,000 and it was completely destroyed, you would not receive the full $750,000. Instead, your $750,000 limit would be reduced by a percentage equivalent to the difference between the true replacement cost ($1 million) and 80% of the replacement cost. In most policies, the coinsurance clause is triggered at 80%, but it can vary. As you can see, the greater the difference between your insured value and the true replacement value, the less of your insured value you will receive in the event of a claim.
So, why do people underreport their values and risk coinsurance? Some homeowners do it out of ignorance of their home’s true replacement cost. Others do it on a mistaken belief they can save some insurance premium dollars because they think they will not likely suffer a total loss, so they feel comfortable reporting a lower insured limit. Unfortunately, this creates a problem for the insurance company because they base their premiums on your home being fully insured. Just as the homeowners believe there is a lower likelihood of a total loss than a partial loss, the insurance company’s premium is also based on the same assumption. In the example above, if you insured the $1 million home for the full limit, the first $250,000 of the limit has a higher probability of loss than the last $250,000 (from $750,000 to $1 million). However, your insurance company doesn’t charge different premium rates for different parts of the limit because instead, they average the risk across the $1 million limit and charge you one rate.
This means that if you are insuring the $1 million home for less than $1 million, you can create an imbalance in their equation. That imbalance potentially creates greater risk of payment for the insurance company at a level higher than the premium charged. To keep homeowners honest, the coinsurance provision was created. With the penalty built in, the homeowner has less incentive to underreport the insured value, and the small amount of premium savings would be more than offset by the coinsurance penalty in the event of a claim.
By property reporting the correct replacement cost of your home to the insurance company, you can avoid the coinsurance penalty regardless of what city you live in – Arlington, Albuquerque, Cleveland, Atlanta, Colorado Springs.