E&O Insights: Co-Insurance Penalty

Co-insurance penalty. Trust me these are not the words you want to hear from your customer right after a claim. How confident are you that your customers know: 1) if they have a co-insurance provision in their property coverage, and 2) what it means and exactly how it works? If you have some serious doubts, there are some options to consider.

But before looking at those options, one more question. How confident are you that your staff (producers and CSRs) is proficient in its knowledge of co-insurance and is somewhat polished in how to explain it? In many respects, there are few more important provisions in a commercial property policy than the issue of co-insurance. It is not surprising that when looking at the errors and omissions (E&O) claims that come from the handling of a commercial property policy, a shortfall in the claim due to a co-insurance penalty is one of the most common.

When discussing the right property limit with prospects and customers, presuming the policy is written on a co-insurance basis, it is really not possible to have this dialogue without interjecting the impact of the co-insurance provision.

Let’s start with the staff. At an upcoming staff meeting, bring up the issue of co-insurance and encourage a role play to see how well the staff can explain it. They may be uncomfortable, but it is important to emphasize that it is better for them to “trip and stumble” among each other than with a customer.

Here is a common example illustrating the point:

At the onset of coverage, you insure a building for $800,000 (presuming an 80 percent coinsurance clause) you believe would cost $1 million to replace. A fire loss causes $400,000 damage. In the settlement of the claim, the carrier determines the replacement cost of the building is $1.25 million and thus, based on the 80 percent co-insurance clause, the building should have been insured for $1 million. Since the building was not insured to value, the carrier will invoke a co-insurance penalty.

To determine how much they will pay on the claim, the insurer divides the amount of insurance purchased ($800,000) by the amount you should have purchased – $1 million (80 percent of $1.25 million). This results in a 20 percent shortfall. The carrier then pays $320,000 (20 percent less than the amount of the loss).

What will be the reaction of the customer who just received 20 percent less than what is needed for them to rebuild? Not happy, to say the least!

Without a doubt, it is better to have this discussion with the customer before the loss instead of after it.

Obviously, various claim examples will be affected by whether the coverage was written on an actual cash value (ACV) basis or on a replacement cost (RC) basis. Plus, while 80 percent is probably the most common co-insurance basis, other percentages (90 percent, 100 percent, etc.) could be applicable.

It is advisable to include an example on how co-insurance works in all property proposals. This will impress upon the customer the need to insure to value. If you have a frequently asked questions section on your Web site, include an explanation of co-insurance as well as ACV and RC.

Now, while everyone may have a solid understanding of the concept, the key is to calculate the correct amount at the onset and subsequent anniversaries of the coverage. I am sure you would agree that determining the correct value after the claim leaves you with a problem – basically it’s too late to do anything about it.

Securing a Property Limit

There are many approaches to securing a property limit. In no particular order:

Using the company approximator tool. This could be one they designed themselves or one of the more common industry tools such as MSB. Using one of these is a good starting point and proper use should result in a quality output. However, incorrect inputs will result in questionable outputs. Ensuring you have full and correct information is key. Without this, errors could occur. Whether inputting the incorrect square footage, picking potentially incorrect construction components or assessing the quality of the construction, all could lead to an output drastically off the correct mark.

Using the limit on the current policy. The problem with this approach is that it assumes the correct calculation was done by the prior agent. No guarantees here as: 1) it may not be accurate, and 2) changes to the building could have occurred in the last year, thereby increasing the replacement cost of the building.

Asking the customer what limit they want. Since commercial clients are typically sophisticated regarding rebuilding costs, this approach has a degree of merit. Make sure they understand the various terms unique to property coverage (co-insurance, ACV, RC, agreed amount, etc.). A downside of this is that the customer may want to insure it for what they bought it for. There is no correlation between the right limit amount and their purchase amount.

Requesting that the customer secures a professional appraisal. This is probably the best overall approach. These cost money, but there is no doubt they are worth it.

Pulling the information from various Web sites. I do not suggest this approach as there is no guarantee these sites reflect current and accurate information.

Using what you think is accurate, with the presumption that the carrier will inspect it and catch your errors. This is not a recommended approach. Every carrier has its own guidelines on what they will inspect and there are very few carriers that inspect every location. In the event of a claim against your agency due to an error in the property limit, a defense used by most E&O carriers would involve bringing the carrier in and stating they had either inspected the location or had a chance to inspect it, and that they should have advised your agency of a problem. This does have some merit, but a stronger focus on trying to calculate the right number upfront is preferred.

New Business

For business new to your agency, take the time to secure the necessary data to perform the calculation.

This should involve a visit to the location by the producer/agency loss control specialist to help secure the correct information. Take measurements and ask the necessary questions regarding construction. This will enable you to more accurately determine the insurance to value. Since commercial properties are subject to many variables, clearly state to your customer (in writing) that this is an approximation and the best way to determine a truly accurate replacement cost is to secure an appraisal.

A word of advice for your staff: Caution them on how they should respond if a customer asks whether their property limit is sufficient. In the event of an underlying claim where it is resolved that the limits were inadequate, the client will allege they relied on your advice to their detriment.

Educating your staff and your customers on this important provision is time well spent. This should also assist greatly in calculating the right property amount.