Agreed Value Option to Avoid Coinsurance

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Many commercial property policies include an optional coverage called agreed value. This coverage suspends the coinsurance clause in your policy. That is, if you purchase agreed value coverage, your insurer will not consider coinsurance when calculating your payment for a loss. Note that agreed value coverage will protect you from a coinsurance penalty only if you have fulfilled certain requirements.

What's Coinsurance?

The coinsurance clause appears in the conditions section of a commercial property policy. Its purpose is to encourage property owners to buy an adequate amount of insurance. If a loss occurs, the clause penalizes policyholders who have underinsured their property by forcing them to become "coinsurers." This means that policyholders must pay a portion of the loss themselves.

If coinsurance applies to your property, a coinsurance percentage, such as 80 percent or 90 percent, should appear in the property declarations. The percentage represents the amount of insurance you must maintain. This amount is expressed as a percentage of the value of your insured property.

For example, suppose that you have just purchased a commercial property policy that includes a 90 percent coinsurance percentage. The policy covers your building and personal property, valued at $2 million and $500,000, respectively.

To satisfy the coinsurance condition you must insure your building for at least $1.8 million (90 percent of $2 million). Likewise, you must insure your personal property for at least $450,000 (90 percent of $500,000).

Timing of the Penalty

A primary problem with the coinsurance clause is the timing of the penalty.

Your insurer evaluates your policy limits at the time loss a loss occurs. In the previous example, you satisfied the coinsurance requirements in your policy when you purchased the coverage. Yet, your property could increase in value during the policy period. If a loss occurs and you have failed to purchase additional coverage, your limits may fall short of the amount required by the coinsurance clause. If your limits are insufficient, you will be subject to a coinsurance penalty.

There are a number of reasons why your property may increase in value. Perhaps you have acquired new property, such as furniture or computer equipment, which you didn't own when your policy was issued. Buildings may increase in value during the policy period due to inflation, rising construction costs, or a hot real estate market. You may not be aware that the value of your property has increased until a loss occurs.

Agreed Value Option

As its name suggests, an agreed value is a property value that you and your insurer agree upon at the beginning of your policy period. To obtain coverage based on an agreed value, you must submit a statement of values to your insurer before your policy begins or renews. A statement of values is a list of your insured property (buildings and personal property) that includes the value of each item.

Property values should be expressed in terms of replacement cost or actual cash value, whichever applies under your policy.

A statement of values is normally prepared on a standard ISO form or on a similar form provided by your insurer. Ask your agent or broker for assistance if you need help completing the form.

Once you have provided a statement of values to your insurer, the coinsurance clause in your policy will be suspended for one year (the term of your policy). If a loss occurs, your property will be assessed based on the agreed upon value as long as you have insured your property for that amount. To continue agreed value coverage the following year, you must submit a new statement of values before your current policy expires. If you fail to provide one, your agreed value coverage will lapse and the coinsurance clause will be reactivated.

Limits Must Equal Agreed Value

To obtain protection from coinsurance under the agreed value clause, you must maintain limits equal to the agreed values. That is, if your statement of values indicates that the cost to replace your building is $2 million, you must maintain a building limit of at least $2 million. If a loss occurs and you have failed to maintain the limits shown in your statement of values, you may be stuck paying a portion of the loss. 

Under the agreed value clause, the most your insurer will pay for a loss to damaged property is the proportion that the limit for that property bears to the agreed value of that property shown in the statement of values. For example, suppose that you own a building that you have insured on a replacement cost basis. You have insured your building at a limit of $1.5 million. However, your statement of values indicates that the replacement cost of your building is $2 million. Your policy includes a $1000 deductible.

A severe hailstorm causes $100,000 damage to the roof of your building. Your insurer will compare the agreed value of your building to the limit on your policy. Because you have underinsured your building by $500,000, your insurer will not pay your loss in full. Instead, it will pay only $74,000. Here is the calculation:

$1.5 million (your building limit) divided by $2 million (the agreed value) = .75

.75 times 100,000 (the amount of loss) = $75,000

$75,000 less the $1,000 deductible = $74,000

Business Income Coverage

An option for agreed value coverage is also available under business income insurance. When this coverage is purchased, the coinsurance clause found in the business income form does not apply.

If you wish to initiate agreed value coverage, you must notify your insurer. You must also submit a business income worksheet outlining your projected revenues and operating expenses for each of the following:

  1. The twelve-month period prior to the date on the worksheet
  2. The twelve-month period that follows the inception of your agreed value coverage (typically the inception date of your policy)

To continue the agreed value option each year, you must submit a new business income worksheet before your policy renews. If you have selected this option under business income insurance, the agreed value should be listed in the declarations section of your property policy. This value should equal the coinsurance percentage shown in the declarations multiplied by your estimated net income and expenses (item #2 above).

For example, suppose that your business income coverage is subject to 50 percent coinsurance. Your estimated net income and expenses for the next 12 months is $1 million. Your business income limit must be at least $500,000 (50 percent of $1 million). If you sustain a $100,000 business income loss and your business income limit is at least $500,000, no coinsurance will apply. Your $100,000 loss should be paid in full (if no deductible applies).

In the previous example, suppose your business income limit is only $400,000. You have failed to purchase the required limit of insurance. The most your insurer will pay is $80,000, calculated as follows:

$400,000 limit divided by $500,000 agreed value = .80

$100,000 loss times .80 = $800,000