A dear friend of mine starts out coinsurance conversations (yes, we actually sit around and talk about this sort of thing, usually with a malted adult beverage) with the following disclaimer/statement/warning: "Coinsurance is evil and must be destroyed." While I know he is kidding (at least I used to think so), I also am quite aware that there is a significant amount of truth in his statement.
I believe his statement essentially arises from his experience as an insurance professional and teacher who is aware of a lack of understanding about how coinsurance applies, why it exists at all, where it exists in various policies, and how best to manage it. I'll try to look at all four of these items in the following discussion—not necessarily in the order presented above—by using an agricultural insurance perspective.
Why Does Coinsurance Exist?
I think we can all agree that most insured property losses are going to be partial in nature. Since this seems to be somewhat common knowledge, why would an insured want to purchase insurance on a "total loss scenario" when the odds are that his or her loss will be partial? If you knew that your loss tomorrow would only cost you $26,000, why would you want to insure it for $100,000?
One of the basic concepts that is taught in Insurance 101 is that insurance is a "sharing of risk"; somewhat along the lines of "we are all in this together" thinking. If I only insured a part of my potential loss, yet you insured for all of your potential loss, we would not be truly sharing risk. At best, that would be a disproportionate sharing.
Given that insurance works best with large numbers of insureds, perhaps we should consider coinsurance in this light. The insurance company will still have the same number of claims whether one insures against a total or a partial loss; but, if we allowed people to adversely select the percentage of coverage they wanted, the premiums collected to pay those future claims would not be adequate. Some customers would buy 100 percent of the coverage amount they needed to be whole after a loss while others would buy just 30 or 40 percent to cover their probable partial loss. Given that scenario (and with the understanding that we are all in this together), the fellow who purchased 100 percent coverage would be overpaying, and the one who chose the 30–40 percent option would be underpaying.
Now we also know by using common sense (yeah, I know, it is not all that common) that not everyone will want to purchase 100 percent coverage. So, we are given choices and incentives. I can decide to purchase a property limit that corresponds to 100 percent of my property value, and in exchange for this choice of insuring to 100 percent of its value, I will receive a premium credit on my rate. Since rates are predicated on an 80 percent coinsurance selection, if I choose to insure my property at 80 percent of its value, I will pay the "published" rate per $100 of value. If I select to insure at 90 percent, I will receive a credit just as I would if I were to insure for 100 percent of its value—the credit is just not as great at 90 percent as it is at 100 percent.
Where It Exists in the Farm Property Coverage Forms
If we review the farm property coverages as provided by Insurance Services Office, Inc. (ISO), we find that coinsurance (or its fraternal twin, insurance to value) applies in multiple areas.
In the "Farm Property—Farm Dwellings, Appurtenant Structures and Household Personal Property Coverage Form" (FP 00 12 04 16), it appears on page one of the form under "Loss Condition—Valuation." (Note: whether the form you are reviewing is the 04/16 edition or an earlier one—say the 09/03 edition—this language is the same). Here we see language that states, "If the limit of insurance on the damaged structure is at least 80 percent of its full replacement cost as of the time of loss, we will settle the loss based on the smallest of the following amounts:
- The cost to replace the damaged part of the structure with material of like kind and quality and for like use;
- The amount actually and necessarily spent to repair or replace the structure; or
- The applicable "Limit of Insurance."
That is then followed by a brief section that outlines how the insurer will pay if the 80 percent insurance-to-value language is not met.
There are two following additional items to note here.
- This valuation language applies to both the farm dwelling and the appurtenant private structures insured under the form. This is "insurance to value" language.
- Although we determine building values when the coverage is written (actually the insured should determine, not us), the value that counts in our calculations is the value of the property as of the time of loss.
In the "Farm Property—Farm Personal Property Coverage Form" (FP 00 13 04 16), we see that for unscheduled "farm personal property (Coverage F)," that coinsurance applies at an 80 percent requirement. It states: "You must maintain insurance on unscheduled 'farm personal property' to the extent of at least 80 percent of its actual cash value as of the time of loss. If you fail to do this, the percentage we pay of any loss will be the result produced by dividing the Limit of Insurance actually carried by the required Limit of Insurance."
"Farm personal property" is defined in the "Farm Property—Other Farm Provisions Form—Additional Coverages, Conditions, Definitions" (FP 00 90 04 16) as "equipment, supplies and products of farming or ranching operations, including but not limited to feed, seed, fertilizer, 'livestock,' other animals, 'poultry,' grain, bees, fish, worms, produce and agricultural machinery, vehicles and equipment."
In the "Farm Property—Barns, Outbuildings and Other Farm Structures Coverage Form" (FP 00 14 04 16), coinsurance (in various manners) applies to these items.
- Fences, corrals, pens, chutes, and feed racks (it is a 100 percent requirement based on the value of all covered fences, corrals, pens, chutes, and feed racks)
- Portable buildings and portable structures (100 percent requirement to the value of all portable buildings and structures owned as of the time of loss)
- Valuation—property other than improvements and betterments (80 percent is required)
Both the "Mobile Agricultural Machinery and Equipment Coverage Form" (FP 00 30 04 16) and the "Livestock Coverage Form" (FP 00 40 04 16) contain language under General Conditions, Section 1., Coinsurance, stating that 80 percent coverage is expected at the time of "loss," or the insured will incur a penalty. The policies/endorsements (they can be used monoline or as endorsements to the farm property coverages) specifically state, "The penalty is that we will pay only the proportion of any loss that the Limit of Insurance shown in the Declarations for all/such1 Covered Property at all locations bears to 80 percent of the total value of such property at all locations as of the time of 'loss.'" [Emphasis added.]
Finally, if the insured has elected to provide for "Coverage G—Barns, Outbuildings and Other Farm Structures—Blanket Insurance" utilizing the FP 04 28 04 16 endorsement, that also includes coinsurance language that states, "The most we will pay for loss of or damage to Covered Property under Coverage G is the proportion that the limit of insurance shown in the Schedule bears to 80 percent of the total 'value' of all Covered Property under Coverage G which you own at all 'insured locations' listed in the Schedule as of the time of loss or damage." 1
ISO does not provide an option by which one may delete this 80 percent coinsurance requirement (i.e., there is no current option for "agreed value" when it comes to barns, outbuildings, and other structures).
How Coinsurance Applies
Those of you who have been subjected to listening while I have instructed (or have at least feigned listening) will remember that I am an ex-English major, not a math major (I know, it is hard to tell based on my writings). So, as I am wont to state when teaching, "Oh boy, coinsurance, now we get to do math." But it ain't that hard! Even an ex-English major can understand it.
So, here's a brief illustration just to remind all of us how it works. Since the farm property coverage forms do not provide us with an example, I'll use a commonly used example in other forms and texts—after all, coinsurance is coinsurance.
- The property value at the time of loss is $250,000.
- The coinsurance requirement is 80 percent.
- The limit of insurance is $100,000.
- The applicable deductible is $250.
- The loss amount is $40,000.
First, we need to determine if a penalty applies. To do so, we need to first determine the amount of the promise that the insured needed to meet: 80 percent of $250,000 equals $200,000. That is the amount of insurance the insured promised to keep in force as of the time of loss.
The amount that the insured did carry was $100,000. Now, $100,000 divided by the amount that the insured should have carried ($200,000) comes to a percentage of 50 percent. (Something tells me that this is not going to be a pleasant situation.)
The insured will now be overjoyed to discover that, because he did not meet his promise of carrying 80 percent, he gets to contribute to the loss to a greater extent than just the deductible. Or, if you prefer, the $40,000 loss is reduced to a payment of 50 percent of the loss ($20,000 minus the applicable deductible of $250) for a net payment of $19,750. Ouch!
How Best To Manage Coinsurance
On the farm property side of things, we are somewhat limited in how to solve this dilemma for our customers. There is no "Agreed Value" endorsement that is readily available from ISO as there is on the commercial property side of things.
To my mind, the way to manage coinsurance with farm/ag accounts that are written under the farm property coverage forms is one of education. In my experience, most farm/ag customers are pretty good risk managers. After all, the farming business almost requires that insureds understand and operate in a culture of risk management application. They constantly—as a way of life and operation—assess risk, determine how to take it on or not, and then act accordingly. So be it with coinsurance.
The reason many agents (I believe) do not discuss this is because they either look at it as "I don't want to get into the weeds with my customer … he won't understand it," or the agent doesn't understand it! Well, farmers understand weeds, they just don't necessarily like them! It is necessary to have the discussion so that when a loss occurs, they will not be surprised.
My simple explanation to a farm account goes something like this: "Mr./Ms. Farmer, when you have a property loss, do you want the insurance company to pay you in full (or as close as we can get to it) minus your deductible, or would you rather have a surprise at the time of loss that ensures you will not receive your full payment?" Given that explanation, would you care to guess what the vast majority of accounts decide?
So, while I may not be able to achieve my friend's mantra of "coinsurance is evil and must be destroyed," I can, at the very minimum, educate my clients as to their responsibility when they purchase an insurance contract. After all, when it comes to coinsurance, "ignorance is not bliss."