Insurance-to-Value Provisions

     When applying for insurance, each property insurance buyer must decide what policy limits to request.  Insurance-to-value provisions found in many property insurance policies encourage the insurance buyer to purchase policy limits that reflect the values exposed to loss.

     Both the insurance buyer and the insurance company give some "consideration" in exchange for an insurance-to-value provision. The insured agrees to accept a penalty if it is determined, after a loss, that the property was not insured to value. In exchange, the insurance company provides insurance at a lower premium rate.

Example of Insurance-to-Value Requirement    The most common insurance-to-value provision is the coinsurance clause. The insured agrees to accept a penalty if a covered loss occurs and the property is not insured for its full value. The penalty is determined by using the following formula to compute the amount paid by the insurer:

    Suppose a property insurance policy covers The Balloon Building for $60,000. The policy contains a coinsurance clause specifying that a coinsurance penalty will apply if the building is not insured for 100 percent of its insurable value. Suppose the full insurable value of The Balloon Building is $100,000. Here is how the loss would be adjusted if a $10,000 loss occurs.

     The building was insured for 6/10 of the amount required by the coinsurance clause. The insured receives 6/10 of the amount that would otherwise be paid for a loss.

    Many property insurance policies contain coinsurance clauses requiring 80 or 90 percent insurance-to-value. Suppose the policy on The Balloon Building had an 80 percent coinsurance clause. In that case, the amount of insurance required would be 80 percent of $100,000, or $80,000, and the loss would be adjusted as follows:

    In both examples, The Balloon Building was not "insured to value" because the amount of insurance carried was less than the amount required. Suppose, instead, that $80,000 of insurance was carried on The Balloon Building. With a100 percent coinsurance clause, the loss would be adjusted as follows:

With an 80 percent coinsurance clause, the following calculations would apply:

In the last example above, the loss is paid in full. No coinsurance penalty is involved because the building is insured to value. That is the way coinsurance usually works, and that is the way it is supposed to work, because coinsurance requirements encourage people to buy enough insurance to avoid the penalty for underinsurance.

    A few additional remarks are necessary:

1. For the sake of simplicity, the above calculations do not consider deductibles. Deductibles would also apply in most property insurance claims
2. The amount paid by the insurer would never exceed the amount of insurance carried, even if the policy provides the full amount of insurance required. Thus, in the final example above, the insured would never collect more than $80,000, even if a loss of, say, $90,000 were sustained.
3. The amount of insurance required depends on the valuation provision that applies to covered property. If the policy on The Balloon Building covered its actual cash value, the amount of insurance carried, the amount required, and the loss would take depreciation into account, If the policy covers replacement cost, then all three figures would be based on the replacement cost value of the building.

    Reasons for Insurance-to-Value Provisions Insurance-to-value provisions encourage insurance buyers to purchase an amount of insurance that reflects the full insurable value of the property (or at least a high percentage, Property and Liability Insurance Principles such as 80 percent, of the fun insurable value). The possibility of a penalty leads them to consider obtaining insurance before rather than after a loss. Thus insurance-to-value provisions reduce the chance that insurance companies will have unhappy policyholders who did not recover in full after a covered property loss.

    Insurance-to-value requirements also lead people to purchase higher amounts of property insurance, thereby increasing the premiums that insurance companies collect in relation to the values of properties insured. Because premium levels are higher, insurance companies can reduce their premium rates, charging each policyholder less for each dollar of coverage. And since all policyholders purchase more realistic amounts of insurance for the property they insure, these rates more accurately reflect the values actually exposed to loss.

What If Property Insurance Policies Did Not Encourage Insurance-to-Value?

    The following example shows what could happen if property insurance policies did not encourage insurance-to-value.

     Perkins Motel owns ten identical cottages, each with an actual cash value of $10,000. Because the cottages are 50 feet apart, the owner realizes that most perils would never affect more than one cottage at a time. Therefore, the owner purchases $10,000 of insurance providing blanket coverage on an ten cottages.

    The ten cottages are later sold to ten people who occupy them as residences. Each person purchases $10,000 of insurance on his or her cottage.

    In the first case, $10,000 of insurance covered most foreseeable losses to $100,000 of property belonging to one insured. In the second case, ten insureds had to purchase $10,000 of insurance, for a total of $100,000, to protect their interests against foreseeable losses.

    The approach above does not make good sense because the loss exposures of the insurer are about the same in both cases. In both cases, a $10,000 loss could be incurred by a fire starting in anyone of ten buildings. To collect an appropriate premium, the insurance company should charge the motel owner ten times as much as each cottage owner. Yet, that hardly seems equitable. With a $10,000 policy limit, the motel owner would not have enough coverage to pay for a loss that destroyed more than one building.

    A coinsurance clause would not permit the motel owner with $10,000 of coverage to collect $10,000 for damage to any one building, To protect all buildings properly, the motel owner would have to buy enough insurance to cover the value of an buildings and pay an appropriate premium.