Building Valuation & Coinsurance

As a Property and Casualty Underwriter, I encounter many different sized properties every day. One common struggle I’ve found among most insureds, regardless of the building's type or size, is figuring out how much property insurance they truly need. Many property losses we see are not a total loss but rather a partial loss. Because of this, some people like to roll the dice and limit the amount of insurance they purchase to reduce upfront costs. While this might seem like a grand idea at first, there are potentially harsh ramifications insureds may not find out about until a claim is filed. 

To protect your insured from suffering financial hardship due to being underinsured, there are a few crucial points to discuss before signing the dotted line and securing a policy. One of the first things to consider is the type of building valuation, and we typically see the following property valuation methods, as listed below!   

  

Replacement Costs is a popular method of valuation. It is the amount it takes to replace damaged or destroyed property with new buildings, equipment, and equal kind and quality furnishings. However, this option is usually more expensive than other valuation methods.   

  

Another popular valuation method that also considers the cost to repair or replace damaged property. However, this method applies a deduction to account for the depreciation of the original property.   

In a situation involving older buildings that are harder to replicate, Functional Replacement Cost is one of the more common valuation methods used. These older buildings can be challenging to replicate either because of technological changes or their unique features. This method also changes the basis to the cost to repair or replace the damaged or destroyed property with equivalence property.  

  

While agreed value is not precisely a valuation method, it is a coverage option that allows policyholders to insure a building at an amount that both the insured and insurer agree the property is worth. Carriers often require a recent appraisal of the property, statement of values, or a detailed explanation of how the value was determined to use this option. The main difference with Agreed Value is that this option waives the coinsurance clause. Speaking of which, let us get into it!   

When it comes to property insurance, the concept that I receive frequent questions about is coinsurance. Many people get the general idea of coinsurance but are not sure how to explain it or understand its importance. So, a more formal definition of the coinsurance provision in property insurance requires the insured to carry an amount of insurance equal to a specified percentage of the insured property's total value. We typically see a coinsurance percentage of 80%. This means if the insured had a building valued at $300,000, they would need to carry a limit of $240,000.  

 

So, why is this such an important topic?
  

Suppose the insured doesn't carry an amount of insurance equal to that specified percentage of the total value and suffer a loss. In that case, they will not collect the full amount of the loss and bear a portion of the loss that would have otherwise been covered. In other words, if they decide to carry less coverage than needed, they will handle more of the claim payment.   

Let's say we have the same example mentioned above, with a building valued at $300,000. We know with the 80% coinsurance clause that the insured must have a building limit on the policy of at least $240,000.   

  

But what happens if they have a limit less than that on their policy?  

For this example, we will say the insured has a building limit of $168,000 on their policy and a deductible of $1,000, and they suffer a loss of $50,000. The rest of the example involves a little bit of math, which can be demonstrated below in 4 simple steps.   

1.) We would first need to multiply the value of the property by the coinsurance percentage. In this case this would be $300,000 x 80% = $240,000. This is the amount of insurance they should have had to comply with the coinsurance requirement.

2.) $168,000 (amount they have) / $240,000 (amount they should have had) = 0.7

3.)$50,000 (amount of loss) x 0.7 = $35,000

4.)$35,000 - $1,000 (deductible) = $34,000 
          a. This is the most that the insured would be paid for the loss. The remaining $16,000 would not be covered since the insured did not meet the 80% coinsurance requirement.   

 

Although this is not a complete list of things to consider when obtaining a property insurance policy, this is a great place to start! As always, it is best to have these conversations with your insured as early as possible to help avoid the unpleasant situation of having to let them know after a claim that they're underinsured and responsible for more of the claim payment than they originally bargained.