Coinsurance is a common provision in property and health insurance that helps to keep premiums affordable by requiring the insured to bear some of the costs directly, so that the insured will seek the best prices or reduce the use of services for minor problems. In other words, the insured acts as co-insurer by bearing some part of the loss. Coinsurance lessens both moral and morale hazards that insurance commonly creates. In property insurance, coinsurance lessens underinsurance by requiring the insured to pay a certain percentage of his losses or expenses that is proportional to a specified amount of the underinsurance. In health insurance, coinsurance requires the insured to pay a certain percentage of medical bills in health insurance so that the insured will shop around for lower prices.
Coinsurance exists in property insurance because premiums are based on the frequency of loss and the amount. However, total losses are less frequent than partial losses, and therefore, the premium per $100 of property value will be less for a total loss than the premium per $100 of value for a partial loss. Without coinsurance, many people would only insure for partial losses, since partial losses are more likely to happen, and the premiums would be lower since the amount insured would be less. However, if insurance companies calculated premiums for partial losses, then people who wanted full coverage would be paying a higher premium than such coverage would otherwise command. Therefore, coinsurance helps to achieve equity in rating by requiring underinsured claimants to pay more.
Some insurance companies use graded rates, instead of coinsurance, which are discounts that are proportional to the percentage of the property value that is insured. However, most companies do not use graded rates, because it requires a property appraisal and the appraisal may not be valid for long if property values fluctuate rapidly, as real estate does in hot markets, for instance.
Insurance companies require property to be insured by a minimum percentage — usually 80% — to be insured up to the face value of the policy. If it is less than that, then the insured must pay a percentage of the loss equal to the percentage of the carried insurance over the required insurance. The 80% figure rather than the 100% figure is used to account for inflation. Since most property values rise over time, if there was a 100% requirement, then a coinsurance payment may be required in a loss that occurs even 1 year after the purchase of insurance. Note that the insured would have to decide how much insurance to carry above the required amount. If the property value is unlikely to increase because of inflation or appreciation, then the insured would save money by carrying only the required amount of insurance, since carrying more insurance incurs higher premiums, but the insurance company will never pay more than the actual cash value or replacement cost or whatever is stipulated in the valuation clause of the insurance contract because it would violate the principle of indemnity. Likewise, the insured would not benefit from overinsurance, which is paying for coverage exceeding the property value.
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Example: Calculating the Property Coinsurance Payment
A business partially insures property worth $250,000 for $100,000, with a policy that requires at least 80% of its value to be insured for full coverage, and which has a $1,000 deductible, and then suffers a $20,000 loss. Since the amount of insurance required for full coverage = .8 × $250,000 = $200,000, the business would have to pay ½ of that loss, since the property was only insured for half of the required amount of insurance. Using the above equation, the business would have to directly bear the cost of $20,000 × $100,000/$200,000 - $1,000 = $9,000.
Inflation and rapidly fluctuating property values can lead to a coinsurance payment even if the insured has chosen to fully insure his property. Property values can fluctuate widely and rapidly because of differing levels of inventory, for instance. To solve this problem, some insurance companies have a reporting form that allows the insured to update the value of the property as needed. Another solution is to provide an agreed value optional coverage, where the value for full insurance is agreed upon before any losses.
Another problem for the insured concerning coinsurance and inventory is the amount of effort that may be required to inventory both losses and remaining goods to determine whether a coinsurance payment will be required, so some insurance policies provide a waiver of inventory clause that stipulates that the insurance company will pay for any loss that is less than 2% of the value insured without the need to take inventory, thus, sparing the insured of a possibly significant task for a small claim.
How Coinsurance Yields Fair Premiums
Premiums are determined by the amount of loss and its frequency in a sample.
Property insurance premiums are based on $100 units of property value; therefore, the base premium is determined by the frequency of loss.
Partial losses are more frequent than total losses. Therefore, the 1st unit is always lost in any loss event, but the last unit of a property will only be lost if it is a total loss.
Therefore, the premium needed to cover losses, if each $100 unit of value were considered separately, for the 1st unit would be much higher than for the last unit. The average premium needed to cover losses would decline continuously for each additional unit that is insured.
However, since underwriting risks and premiums are determined from actuarial studies of actual populations that records the total amount of losses and its frequency of occurrence, a premium rate cannot easily be determined separately for each $100 unit of property, and would be difficult to market, since a separate quote would be needed depending on how much of the property the insurance applicant wanted to insure.
If the premium were set to cover the 1st unit of loss or the average loss, then people who wanted complete coverage would pay too much.
If the premium was based on the entire property being insured, then many people would save money by insuring only part of the value of their property, since total losses are rare, in which case, the insurer would lose, because the premium would be too low for the risk.
Coinsurance allows insurers to quote a single premium that is contingent only on the amount. People who would insure for less than the required amount would have to pay a coinsurance penalty that is commensurate with the underinsurance.
In economics, there is the well known relationship between supply and demand — when supply prices are up, demand is down, and vice versa. However, the law of supply and demand breaks down when payment is provided by a 3rd party — in this case, insurance companies. If people don't have to pay directly for a service, but, instead, have insurance which pays for the service, then there is little motivation to shop for the best prices. And since patients are unconcerned about price, medical providers will raise their prices readily since, without a reduction in demand, this will increase their profits proportionately. This will, in turn, raise insurance rates for everyone, making health insurance even more unaffordable than it already is.
By making the insured pay a certain percentage of their medical bills, coinsurance, which is stipulated by the percentage participation clause in health insurance contracts, helps to keep premiums down by giving patients a vested interest in shopping for lower prices. Most policies have an 80/20 or 75/25 coinsurance clause that requires the insured to pay 20% or 25% of the medical bill above the deductible and co-pay.
Many insurance companies will also require the patient to pay a co-payment (aka co-pay), which is a small, set fee that is independent of the total amount of the bill, but must usually be paid when the service is rendered. The co-pay is usually $25 or less.
Another benefit to coinsurance is in the reduction of demand for medical services. When something is free, or nearly so, people tend to consume free services or products even when they do not need them. Coinsurance helps to prevent this waste by requiring the insured to pay not only the deductible, but also a significant percentage of the bill above the deductible. Thus, people will more carefully consider whether they really need medical treatment, and if they do, they will be motivated to shop for better prices.