While policyholders should strive to provide the insurer with complete and accurate values for buildings and business personal property that are the subject of insurance, policyholders should also understand the basic workings of the co-insurance condition. In this article, authored by Craig Stanovich, we’ll review potential penalties for underinsurance.
Meet Mitch – a commercial real estate investor, who owns, under his real estate corporation, over 50 buildings located in the city, as well as the nearby suburbs. Mitch’s real estate portfolio consists primarily of leased retail and office space, with some service occupancies, as well. Mitch is preparing to purchase another building in the city and is arranging a mortgage with a new lender – Paperless Lending. To his surprise, the lender has rejected an insurance binder obtained by his risk manager Jess, from his insurance agent. Paperless Lending does not accept building insurance with co-insurance – and the binder given to Paperless Lending lists 90% co-insurance clause.
Co-insurance As Mitch relies on his risk manager Jess, to understand his insurance coverage, he has never read his insurance policies. But now he is alarmed by “co-insurance,” as it seems to Mitch – based on his limited dealings with health insurance – that his insurance company will never pay more than 90% of any loss that he has, regardless of the amount or limit of insurance he has purchased. This sounds problematic, and he immediately arranges to meet with Jess and his insurance agent, Diana, to discuss this matter.
Co-insurance Explained At Mitch’s request, Jess and Diana explain the concept of co-insurance. At the outset, they make clear to Mitch that co-insurance in property insurance is not the same as the 80/20 cost sharing in some health insurance policies. Instead, in property insurance, co-insurance generally means Mitch must purchase a certain limit of insurance on his building – the limit purchased must be no less than a denoted percentage of the full value1 of the building. Here, the percentage is 90%. Because Mitch did obtain, as part of his due diligence, a professional appraisal that determined the replacement value of his building as $5 million, Jess and Diana tell Mitch that he must purchase a limit of no less than 90% of $5 million or $4.5 million. If he does not purchase a building limit of at least $4.5 million, Mitch will face a penalty as a “co-insurer.”
The Co-insurance Penalty Jess refers Mitch to the pages of his property insurance policy, which provide two straightforward illustrations of the concept of co-insurance – including the penalty for being underinsured and what constitutes adequate insurance.2 Jess suggests to Mitch an example using his situation as a hypothetical – what would happen if he purchased less than 90% of the $5 million limit? Let’s say that Mitch bought a limit of $3 million (the amount of his loan principal). If Mitch then had a relatively small covered loss – say a $200,000 water damage loss caused by a broken pipe – he would be penalized as a co-insurer. He would be penalized because the insurer would, at the time of the loss, calculate whether Mitch had complied with the co-insurance condition.
The Co-insurance Formula To determine compliance with the co-insurance condition, the insurer would first ascertain the replacement cost of the building ($5 million) and then note the co-insurance percentage (90%) on the policy – and thus conclude that Mitch should have purchased $4.5 million ($5 million times 90%). But Mitch (in the hypothetical situation) did not meet the co-insurance condition – the limit purchased was $3 million, not the $4.5 million limit that he should have bought. The insurer would compute the co-insurance penalty by dividing the limit Mitch did purchase ($3 million) by the limit he should have purchased ($4.5 million), thereby yielding a percentage of 66%. This percentage (66%) would then be multiplied by the amount of the water damage loss ($200,000), producing a loss payable of $133,333, which is further reduced by Mitch’s deductible. The result is that Mitch would suffer a co-insurance penalty of $66,666 and he would be a 33% “co-insurer.” After further discussion, Mitch now understands the co-insurance formula – did (purchase) divided by should (purchase) may result in a reduction in payment for even small or partial losses.
Blanket Building Limit Jess now refers Mitch to a third example3 in the policy regarding co-insurance – how co-insurance is determined if the policy is written with a blanket limit. Mitch’s commercial insurance policy provides a blanket limit for all his buildings, with one limitation that Jess promises to explain later.
A blanket limit4, according to Jess, means that one limit applies to more than one type of property or one limit applies to the same type of property but to more than one location (or both). As Mitch is insuring only the buildings, the blanket limit in this situation applies to the same type of property (buildings) over numerous locations. One limit of $250 million applies to all of Mitch’s listed buildings (again, with one exception). The benefit of this approach becomes evident to Mitch. In the event of certain5 covered losses to one or more of Mitch’s listed buildings – such as may be caused by a hurricane – Mitch has up to $250 million of insurance (in most instances).
Co-insurance and Blanket Limits Blanket limits change the calculus of co-insurance. While the formula is the same – “did divide by should times the loss“ – with a blanket limit, the insurer must determine compliance with the co-insurance condition using total aggregate values. In Mitch’s case, for the insurer to calculate whether he has met the co-insurance condition, the insurer must use the $250 million limit (did), ascertain the insurance limit required (should), which is 90% of the full replacement value of all Mitch’s buildings (an onerous undertaking at best) and then multiply that percentage by the $200,000 water damage loss. As Jess points out, this provides more room for error – if a few buildings are a bit underinsured, but some others are over-insured, the chance of applying a co-insurance penalty is reduced.
Margin Clause Two locations that Mitch owns do not have an automatic sprinkler system that is to the insurer’s liking. While the insurer did provide coverage for these two buildings and include both locations within the $250 million blanket building limit, the insurer also added a Margin Clause endorsement6 for these two locations. Mitch recalls that Jess had promised to explain this limitation to him.
The explanation is this: for these two locations, the insurer will not pay up to the $250 million blanket building limit, but instead will pay no more than values last reported for each building multiplied by the percentage shown in the Margin Clause endorsement. While the percentage ranges from 105% to 130%, Mitch’s policy lists in the Margin Clause endorsement 120% for each of the two buildings (reported as locations #16 and #42.) If the building at location #16 was reported as $3 million and location #42 was reported as $6 million, the true limit applicable to each location is $3.6 million ($3 million times 120%) and $7.2 million ($6 million times 120%).7 The effect of the Margin Clause in Mitch’s policy has been to eliminate these two locations from receiving the benefit of the full $250 million blanket building limit.
Paperless Lending’s Error – The Agreed Value Optional Coverage At the end of the discussion regarding co-insurance and the blanket building limit, as well as the margin clause limitation, Diana addresses Paperless Lending’s rejection of the binder. While the binder does show a 90% co-insurance, Paperless Lending failed to notice the co-insurance condition did not apply to any building on Mitch’s policy – the binder clearly listed that Mitch had purchased the Agreed Value optional coverage.8 Diana will explain to Paperless Lending that the agreed value option effectively suspends the co-insurance condition to the end of the policy period and that Paperless Lending should accept the binder, as the 90% co-insurance condition does not apply to the new building. Diana tells Mitch the agreed value option was provided to Mitch only because the insurer believed the values reported for each building were a reasonably accurate estimate of the full replacement value of each.
Conclusion While policyholders should strive to provide the insurer with complete and accurate values for buildings (and business personal property) that are the subject of insurance, policyholders also should understand the basic workings of the co-insurance condition, including the potential penalties for underinsurance, as well the purpose of the agreed value option, blanket limits and margin clauses, if applicable. Even a cursory review of the basic illustrations found in the co-insurance condition of the Building and Personal Property Coverage Form should inform any policyholder of the penalties of underinsurance and thus the need for adequate insurance. Stated differently, no special skill or expertise in insurance is needed to make sense of the co-insurance illustrations – taking only a few minutes to read the examples provided in every Building and Personal Property Coverage Form9should suffice.
1 If the Optional Coverage of Replacement Cost is purchased, the measure of the building value is the full replacement value of the building. If the Optional Coverage Replacement Cost is not purchased, the measure of the value of the building is the full actual cash value of the building. See Building and Personal Property Coverage Form CP 00 10 10 12 © Insurance Services Office, Inc. 2011.
2 See Building and Personal Property Coverage Form CP 00 10 10 12 – F. Additional Conditions 1. Coinsurance – Example 1 to Example 2 © Insurance Services Office, Inc. 2011
3 See Building and Personal Property Coverage Form CP 00 10 10 12 – F. Additional Conditions 1. Coinsurance – Example 3 © Insurance Services Office, Inc. 2011
4 A blanket limit may be incorrectly referred to as a blanket policy. The two should not confused – the former refers to how the limit applies, the latter often refers to a policy that covers property that is not listed on the policy or covers property, not at a location specifically listed on the policy.
5 Sublimits apply to certain causes or types of loss such as Earth Movement, Flood, Ordinance or Law, etc.
6 CP 12 32 06 07 – Limitation on Loss Settlement – Blanket Insurance (Margin Clause) © Insurance Services Office, Inc. 2007
7 Margin clauses (non-ISO) are also used enhanced the applicable limit. For example, a specific building limit is shown as $1 million for that building with a margin clause of 110%, effectively providing a limit of $1.1 million.
8 See Building and Personal Property Coverage Form CP 00 10 10 12 – F. Optional Coverage 1. Agreed Value © Insurance Services Office, Inc. 2011
9 While this article is based on the latest (October 2012 edition) of the ISO Business and Personal Property Coverage Form CP 00 10, the illustrations have been included in this policy form for over 30 years.
This article by Craig Stanovich, was originally published by AmWINS Group, Inc., and edited and adopted by Paperless Insurance Services. Legal Disclaimer: Views expressed here do not constitute legal advice. The information contained herein is for general guidance of matter only and not for the purpose of providing legal advice. Discussion of insurance policy language is descriptive only. Every policy has different policy language. Coverage afforded under any insurance policy issued is subject to individual policy terms and conditions. Please refer to your policy for the actual language.