Underinsuring your property exposes you to more than loss risk. It could trigger coinsurance penalties.
Believe it or not, some people deliberately underinsure their property just to save a few pennies on insurance premiums. The old saying of pennywise pound foolish certainly applies in these cases. Other policyholders don’t know they’re underinsured because they haven’t kept track of appreciating property values over time. When a partial loss occurs, they find out the hard way about coinsurance penalties after the insurer determines that the policyholder was underinsured beyond the limits specified in the policy.
What’s a coinsurance penalty? Basically, the insurer won’t pay you the full settlement amount on losses if you don’t buy sufficient coverage for your property. The thinking is that if you underinsure you must take on some of the risks if a loss occurs.
Insurance companies want you to purchase coverage equal to 100 percent of the replacement value of the property, or as close to it as possible. Most policies specify that the coverage must equal at least 80 percent of the full replacement value of the property, though some set it at 90 percent. If your coverage falls short, you might be surprised how badly the coinsurance penalty can hurt you.
Here’s how coinsurance provisions can work against you if you underinsure. If your property is valued at $100,000, the typical policy will require at least $80,000 of coverage. Now, for whatever reason, possibly to reduce premiums, you buy half the required coverage, leaving you grossly underinsured. Then you suffer a partial loss of $40,000. Because you only bought half the required coverage stipulated in the policy, the insurer will only cover half the partial loss ($20,000). The settlement payment is based on the ratio of the amount of coverage actually purchased divided by the coinsurance percentage listed in the policy. Deductibles apply on top of the coinsurance penalty.
Yes, it gets complicated. For example, how do you know how much a property is worth? Obviously, an appraisal is the most logical way to find out. Depending on your circumstances, an appraisal every three years makes sense, especially if you think the property has greatly appreciated in value. Insure to 100 percent of replacement value. When your property value increases, you’ll have that 20 percent cushion before the coinsurance penalty applies in the event of a partial loss.
Your insurance agent should know about coinsurance provisions. Ask about this arcane aspect of insurance, and if the agent can’t explain it, find someone else. Make sure you know if your policy includes a coinsurance clause when you buy the insurance. In some cases, your insurance agent can negotiate with the insurer to eliminate the coinsurance clause in favor of an agreed-upon-value clause.
Bottom line? Buy enough property insurance to sufficiently cover losses, and to protect yourself from coinsurance penalties.