Agents have a special obligation to properly explain the implications of a coinsurance penalty in regards to his or her client’s insurance needs. Most insureds have no idea what a coinsurance penalty is, or how it works. It is vitally important for agents to fully explain the coinsurance penalty to every insured.
The risk of a total loss to a structure is fairly small. Accordingly, many insureds may choose insurance limits that are less than what are needed to replace the entire structure. From an actuarial standpoint this may be a very sound idea. However, most insurance policies contain a coinsurance penalty that reduces what the insurance company has to pay in the circumstances where the structure is underinsured.
For example, assume a $1,000,000 structure insured for $500,000. In this case, the insured will think that the insurance company will pay for any damage up to $500,000, and the insured will be on the hook for any damage over $500,000. While this may seem like a reasonable business decision under the insured’s particular circumstances, the coinsurance penalty will raise its head to thwart the insured.
In this situation, further assume a fire which causes $200,000 in damage. No problem right? The $200,000 is less than the $500,000 limit and the insurance company should be on the hook for the whole loss minus the deductable. Wrong. Here the coinsurance penalty, depending on the penalty amount, will reduce the amount owed by the insurance company up to 90%.
In a case I filed last week, I’ve sued my client’s insurance agent for failing to properly explain the coinsurance penalty. In that case, the limits of insurance are more than enough to pay for the damages caused by a fire, but because of the coinsurance penalty, my client will only be receiving about 20% of the amount needed for repairs. Had the agent explained the coinsurance penalty to my client, he would have increased the limits of insurance, and thereby recovered all of his losses. The agent’s failure to even mention the coinsurance penalty has cost my client over a half-million dollars thus far.