Handling hundreds of commercial property insurance claims every year, we have found that few things cause people more confusion than the concept of co-insurance. This article provides a brief overview of what co-insurance is, why it exists, and how it is calculated.
What is Co-Insurance?
In simplest terms, co-insurance requires that policyholders insure their businesses for an amount equal to at least the value of the covered property or earnings stream, multiplied by the co-insurance percentage.
If the policyholder is looking to save premium dollars by insuring less than the required amount, then they become a “co-insurer” for any loss, and will only recover from the insurer a portion of any loss they suffer, even if the total amount of the loss is less than the policy limit.
Co-Insurance Calculation – A Simple Example
For example, a building valued at $1,000,000 with a co-insurance requirement of 90% must be insured for no less than $900,000.
If the policyholder decides to purchase insurance for less than $900,000, they are agreeing to retain part of the risk rather than transfer it to the insurance company. Therefore the policyholder becomes a co-insurer and will “share” the loss with the insurance company.
Value Insured / Value That Needs to be Insured x Amount of Loss
= Collectible Loss
Using the example above, assume the policyholder only purchased $600,000 of insurance, and suffered damage to the building valued at $300,000. In that case, the insurer will pay the insured the following:
($600,000 / $900,000) x $300,000 = $200,000
Even though the value of the damage was $300,000, since the policyholder only insured 2/3rds of the required value (i.e. $600,000 out of the required $900,000), the insurance company will only pay for 2/3rds of the damage.
Co-Insurance for Business Interruption Losses
Co-insurance also commonly applies to business interruption (“BI”) coverage. In order to recover 100% of any BI loss (up to the policy limit), the insured must have coverage in place equal to its annual BI value (equal to projected revenue multiplied by the gross earnings/profits/business income rate, as defined by the policy).
It can be difficult for policyholders to know how to project how much insurance they will need. This requires both:
- Projecting revenue for up to two years in advance (since a loss suffered towards the end of the policy period will require a co-insurance calculation based on projected revenue over the upcoming year); and,
- Understanding what BI rate to apply to the revenue forecast.
Some general issues to consider in setting business interruption limits so as to avoid co-insurance issues include:
- Is the business in a mature industry or a new start-up?
- What is the overall industry trend?
- Are there any regulatory changes impacting the business?
- Is the business planning an expansion (e.g. business plans/forecasts)?
- Is the company entering new lines of business?
- Does the business experience seasonality?
- Are there any major contracts entered into or expired?
- What are the fixed versus variable expenses of the business?
All of the above general issues may impact the future operations of the business and may cause an insured to need to change the limits of their business interruption coverage.
At MDD, our accountants have worked on numerous matters involving co-insurance issues.