Co-Insurance Clauses

Insurance & Asset Protection

When deciding on the types of fire/hazard property insurance coverage for a small business, an owner needs to consider a number of policy variables.

A property insurance policy may contain a "co-insurance" clause. This clause reduces the apparent amount of insurance when it is triggered, making the insured a "co-insurer" for his own loss.

Generally, the co-insurance clause, which is expressed as a percentage (80 percent is common), will be triggered when the policy limit for the insurance is less than the fair market value of the property multiplied by the co-insurance percentage. In short, the result derived by multiplying the fair market value of the property by the co-insurance percentage represents the minimum amount of insurance that must be carried if the insured is to receive a full recovery for his loss.

Let's say John Smith owns a commercial building with a value of $800,000. In an attempt to save on the premium cost for the policy, Smith insures the building for only $600,000. His theory is that it would be unlikely the building would suffer a total loss, so in effect, he is fully insured.

The policy contains an 80 percent co-insurance clause, and then the building suffers fire damage in the amount of $600,000. Smith feels confident that the loss will be fully covered as the loss equals his policy's limit.

Smith is mistaken. When there is a co-insurance clause, the insured will not receive a full recovery if the amount of the insurance is less than the fair market value of the property multiplied by the co-insurance percentage.

In this situation, the amount received will equal:

The amount of the insurance divided by the co-insurance percentage multiplied by the value of the property and then multiplied by the amount of the loss.

In this example, $600,000 / (80 percent x $800,000 = $640,000) = 0.9375. Then, 0.9375 x $600,000 = $562,500.

Smith is a co-insurer (along with the insurance company) for the loss. Specifically, Smith's share of the loss is $37,500 ($600,000 less $562,500).

Note that there will be a full recovery (subject to the policy limit, of course), if the amount of the insurance is equal to, or higher than, the fair market value of the property multiplied by the co-insurance percentage. Thus, in this example, Smith would have received a full recovery for his loss ($600,000), had he insured the building for at least 80 percent of its fair market value ($800,000 x 80% = $640,000).

In general, when there is a co-insurance clause, the insured will recover the lowest of the policy limit, the value of the loss or the amount derived from the co-insurance calculation.