Coinsurance Penalty in Insurance - What is it?

Insurance policies often include specific terms and conditions that policyholders must understand to avoid unexpected costs. One such term is the coinsurance clause, which can lead to a coinsurance penalty if not properly adhered to. This article breaks down what the coinsurance penalty is, how it works, why it exists, and how to avoid it.

What is Coinsurance in Insurance?

Coinsurance refers to a cost-sharing arrangement between the insurance company and the policyholder. In property insurance, it is a clause requiring the policyholder to insure their property to a specified percentage of its value, commonly set at 80%, 90%, or 100%.

For example, if you own a property worth $1,000,000 and your policy has an 80% coinsurance requirement, you must insure it for at least $800,000. If you insure for less than this amount, the insurer may impose a coinsurance penalty.

What is the Coinsurance Penalty?

The coinsurance penalty is a reduction in the amount of a claim payout when a policyholder fails to meet the coinsurance requirement. This penalty ensures that underinsured policyholders bear part of the financial burden for not adequately covering their property.

How Does It Work?

Here’s the formula commonly used to calculate the penalty:

Example:

• A fire occurs in your building and the estimate to repair is $250,000

• Your property policy has $1,000,000 of coverage (10,000 sq ft @ $100 per) with an 80% coinsurance requirement

• When the claims adjustor comes to view the loss it is determined that the property would cost $200 per sq ft to rebuild for a total of $2,000,000

Using the formula:

The insurer would pay $151,250 of the $250,000 loss, leaving the policyholder responsible for the remaining $98,750.

Why Does the Coinsurance Clause Exist?

The coinsurance clause serves several important purposes:

1. Encourages Adequate Coverage: It motivates policyholders to insure their property for an appropriate value, reducing the risk of underinsurance.

2. Ensures Risk Sharing: By requiring a minimum level of coverage, the clause ensures policyholders take on a fair share of the risk.

3. Promotes Fair Premiums: Insurance premiums are calculated based on the level of coverage. If policyholders underinsure their property, they may pay lower premiums, creating an imbalance in the insurance pool.

   
   

Coinsurance in Health Insurance

While coinsurance is most commonly discussed in property insurance, it also applies in health insurance. Here, it refers to the percentage of healthcare costs the insured must pay after meeting their deductible.

For example:

• If a health insurance policy has a 20% coinsurance requirement and a medical bill is $1,000:

  • The insured would pay $200 (20% of the bill).

  • The insurer would cover the remaining $800 (80%).

This cost-sharing arrangement encourages responsible use of healthcare services.

Common Situations Leading to Coinsurance Penalties

1. Underestimating Property Value: Property values can increase due to market conditions, inflation, or renovations. Failure to update the policy can result in underinsurance.

2. Neglecting the Coinsurance Clause: Some policyholders may not be aware of their policy’s coinsurance requirements, assuming they are fully protected.

3. Intentional Underinsurance: In an attempt to save on premiums, some may deliberately insure their property for less than its required value, risking penalties in the event of a claim.

   
   

How to Avoid Coinsurance Penalties

1. Understand Your Policy: Read your insurance policy thoroughly to understand its coinsurance clause and requirements. If you’re unsure, consult your insurance agent or broker.

2. Regularly Review Property Values: Schedule periodic appraisals of your property to ensure your coverage matches its current value.

3. Insure to Replacement Cost: Insure your property for its full replacement cost rather than its market value, as the latter may be insufficient to meet the coinsurance requirement.

4. Consider Agreed Value Policies: Some insurers offer agreed value policies that waive the coinsurance clause. These policies establish a predetermined value for your property, simplifying claims and eliminating penalties.

5. Work with Insurance Professionals: Experienced agents can help you determine the correct coverage amounts and avoid potential pitfalls.

Additional Benefits of Proper Coinsurance Compliance

Beyond avoiding penalties, complying with coinsurance clauses provides added benefits:

1. Peace of Mind: Adequate coverage ensures you’re protected against financial hardship in the event of a significant loss.

2. Smoother Claims Process: When your policy meets its coinsurance requirements, claims are less likely to be disputed, leading to faster payouts.

3. Improved Financial Stability: By sharing risk appropriately, you avoid unexpected financial burdens and can focus on rebuilding after a loss.

   
   

Conclusion

The coinsurance penalty is a financial consequence designed to encourage policyholders to adequately insure their assets. While the penalty can be costly, it is entirely avoidable with proper planning and diligence. By understanding your policy’s coinsurance requirements, regularly reviewing your coverage, and working with knowledgeable insurance professionals, you can protect your property, avoid penalties, and ensure financial security in the event of a loss.

Whether in property or health insurance, coinsurance emphasizes shared responsibility and risk management, making it a cornerstone of many insurance policies.

References

• Insurance Information Institute (III): Coinsurance Definition and Examples

• National Association of Insurance Commissioners (NAIC): Property and  Casualty Insurance Basics

• Investopedia: What is Coinsurance?