Co-insurance clauses appear in many commercial property and business-interruption insurance policies. Their purpose is to penalize an insured who fails to insure property to an amount equal to a specified percentage of the whole value of a property, either as a commercial choice or because of changes in value during a policy term. The wording of such clauses typically states that an insured that fails to declare a true value on the insured property "will only be entitled to recover that portion of any loss that the amount of insurance in force at the time of loss bears to the amount of insurance required to be maintained by this clause."
Critics of insurance companies assume the purpose of such strictures is simply to encourage insureds to report higher values in order to charge higher premiums but that view represents a one-sided look at the purpose of co-insurance and what co-insurance does. Legally, it is important to understand the underlying and original reason insurance companies introduced co-insurance in order to predict how the courts will interpret and apply such policy terms.
Looked at more broadly, co-insurance is a means of ensuring the accuracy of actuarial data and so maintaining the solvency of insurance companies. Co-insurance also preserves the equitable application of rates charged for insurance and provides a better understanding of risk exposure for underwriting purposes.
Ultimately co-insurance protects the sanctity of the insurance pool, which the Supreme Court of Canada has recognized as a valid concern. Insurers need to know the actual value of the property in order to understand the nature of the risk to which they are exposed—otherwise, they cannot charge appropriate premiums.
Take a partial loss as an example. An insured has a property worth a million dollars but, believing it will never suffer a loss in excess of half that amount, it has informed the insurance company that the property is worth just $500,000. Now, when an insurance company calculates risk exposure, it factors in the likelihood and cost of any type of loss; it analyzes the risk and, assuming it too concludes only a partial loss is possible, the insurer charges premiums accordingly. With this million-dollar property, the insurance company's statistics indicate only a 50% loss will ever occur so it charges a premium based on a maximum loss of $250,000, half of the value reported by the insured.
Assume a loss occurs and half the property is damaged. The insurance company is forced to pay out the policy limit of $500,000 as the value of repairing the damaged property is half of the true property value. If numerous insureds follow this pattern, the insurance company’s income from premiums will be insufficient to meet their obligations under the remainder of their policies.
A controversial area relates to the application of co-insurance to an actual cash value (ACV) settlement on a replacement-cost policy. A replacement-cost policy allows an insured to replace their damaged property with other property of like kind and quality whereas an ACV policy takes the value of the property less depreciation and pays out the netted amount. If a building has a fire, with a replacement cost policy an insured can have the building reconstructed. A newly refurbished building, of course, is more valuable than the building was prior to the fire. With ACV, an insured only receives an amount representing the value of the building when it was new adjusted down for wear and tear over time. The ACV is significantly less than the value of a new building in most cases.
In order to qualify for replacement cost, an insured must meet several conditions including actually replacing the property and proving that the new property is similar in kind to the damaged property prior to the loss. If the insured complies with the terms and conditions to claim replacement cost but they are underinsured, they will be subject to a co-insurance penalty. However, a question arises: does the same co-insurance clause apply in instances where the insured fails to meet the preconditions of replacement cost and instead claims actual cash value?
One theory holds that the insured is already being penalized by being denied replacement cost as a settlement basis and should not also have to suffer the potential effects of the co-insurance penalty. However, in actuality, an ACV settlement is a consequence of the insured's failure to comply with the contractual preconditions of the insurance policy. The settlement basis has nothing to do with the amount of insurance in place. Consequently, there is no reason not to apply co-insurance to an ACV settlement under a replacement cost policy should the insured fail to insure to the applicable minimum level of insurance. In fact, it is consistent to apply co-insurance to either settlement basis.
Co-insurance was originally instituted by insurance companies in order to promote truthful reporting from the insured to the insurance company. Accurate reporting serves an important role in the continued sustainability of insurance and insurance companies. Therefore, the continued inclusion and application of co-insurance to all types of settlement bases is an integral element of a sustainable insurance industry.