The Standard Fire Contract does not have any
clause relating to coinsurance. Even
so, coinsurance is part of many types of policies. It is most likely to be seen in policies protecting manufacturing
and mercantile firms. Outside of property
and casualty policies, coinsurance is frequently used. This is especially true in medical
policies. Coinsurance is not typical in
dwelling fire contracts. When
coinsurance does exist in property and casualty policies, its intent is to
limit the insurers liability.
Even though coinsurance is not necessarily used, the concept has
been in insurance since policies were first created. It was first used in the marine insurance field. Today coinsurance is so ingrained in marine insurance
that it is not considered necessary to even refer to it. It is simply known that the amount of
insurance carried is equal to the full value of the property insured. Anything less and the insured must bear a
proportional share of any incurring loss.
The actual coinsurance
term is not necessarily the same in every type of policy. As a result, it is necessary to refer to the
list of terms in each type of policy.
Coinsurance may be referred to as Average Clause, the Reduced Rate
Average Clause, the Standard Average Clause, the Reduced Rate Contribution
Clause, and the Percentage Value Clause.
Whatever term is used, it limits the
insurers liability. Again, whatever term is used, coinsurance intends to
limit the insurers liability.
The use of coinsurance is widely accepted by consumers. Whether it is called coinsurance in the
policy or stated as an average clause, the results are the same. The application of the 1963 Guiding
Principles actually reduced any real difference between the two terms. The exception might be when coinsurance is
involved in a non-concurrent loss situation.
Briefly, the coinsurance or average clause provides that the
property owner has any loss paid only in the proportion that the amount of
insurance purchased bears to the minimum amount of insurance that the contract
requires the insured to carry. The
insured, of course, is free to buy as much or as little insurance as they
desire.
Simply stated, coinsurance restricts recovery on partial losses
if the insured did not insure the property for a given percentage of its actual
cash value at the time of the loss.
Coinsurance is required in some policies and optional in others. A typical coinsurance clause would read:
In consideration of the reduced rate and/or
form, it is expressly stipulated that in the event of loss this company shall
be liable for no greater proportion than the amount hereby insured bears to ___
percent of the actual cash value of the property at the time of loss nor for
more than the proportion which this policy bears to the total insurance
thereon.
Most homeowner policies insure for 80 percent of the homes
value. The other 20 percent would be a
coinsurance. This provides a reduced
premium rate. In Illinois, for example,
an 80 percent clause in a fire policy on a fire resistant building may reduce
the rate by as much as 70 percent in some central locations. A 50 percent coinsurance may reduce the rate
by as much as 56 percent. The actual
premium reductions depend upon multiple factors, of course.
Most rate reductions come with strings attached. For example, for a rate reduction the
insured might agree to protect the property for an amount equal to at least the
stated percentage of the actual cash value of the covered property at the time
of loss, with the provision that if the percentage is not met, the insured
becomes a coinsurer to the extent of the difference between the amount of
insurance required and the amount of insurance owned. On that basis, the insured will contribute pro rata to incurred
losses.
The complexity of adjusting losses under more than one type of
coinsurance clause is more than we would want to attempt here. That issue could be a course in itself, but
one that few agents would want to tackle.
Some things are better left to the actuaries.
How Coinsurance Works
Coinsurance is typically expressed as a percentage. Most fire policies cover up to 80 or 90
percent, but there are no percentage requirements. Regardless of the percentage used,
the insurer will never cover more than the policys face amount.
There is a formula that is used to figure coinsurance amounts and
the amount of insurance that should be purchased.
Amount of insurance
required:
Actual cash value of the property at the time of loss
X Coinsurance percentage
= Amount of insurance required.
To determine how much the
insured would receive from a covered loss, the following formula is used:
|
Amount of insurance owned |
X Loss = |
Maximum amount of recovery |
|
Amount of insurance needed |
The amount of insurance owned would be the face amount of
the insurance in force. The amount
of insurance needed would be the actual cash value of the property at the time
of the loss multiplied by the coinsurance percentage that is stated in the
policy. There are two situations that
would make this formula wrong:
1.
If the insured carried more insurance than that required
by the application of the coinsurance percentage, payment would not exceed the
amount of the loss.
2.
The insured can never recover more than the face amount of
the contract.
Probably the majority of fire policies written are for 80 percent
coinsurance clause. Assuming this fact,
there are some important points to consider:
1.
If the insured fails to insure at least 80 percent of the
value of the property the coinsurance amount is more than might be
expected. It is unfortunate that the
term coinsurance has been used
to the point of misunderstanding on the part of the consumer. Since different types of policies may apply
the term differently, the insured may easily misunderstand how it affects their
fire policy. If the insured
under-insures their property, there is no recourse once the loss has occurred.
2.
The property owner determines the amount of insurance in
place. Even though the selling agent
may recommend a higher amount, the amount actually purchased is determined by
the buyer. Exact property values may
not always be known by either the agent or the owner. We generally assume the owner will know the value of their
property, but since values change often this is not necessarily the case. In addition, a person who does not deal with
property values is not always in a position to assess property value.
Insurance companies and their agents do periodically send out
notices to their clients expressing the need to update their coverage. While this is appreciated by many it is
ignored as often as it is acted upon.
When the property owner experiences a loss it is too late to correct the
problem if they failed to act on the companys earlier recommendations.
3.
The 80 percent coinsurance clause does not mean that the
company will pay only 80 percent of any loss.
It does not mean that the insured is prohibited from taking insurance
beyond the 80 percent level of the property value. The property owner is free to insure the property to the full 100
percent of its value if they so desire. If the property owner has insurance
amounting to the full extent of the loss, losses will be paid as though the
policy contained no coinsurance clause.
4.
The coinsurance clause becomes inoperative if the loss is
equal to or exceeds the stipulated percentage of value. In other words, while the policy will never
pay beyond the face amount, it will pay up to the face amount. If the loss is substantially greater than
the face amount, the policy will pay that full face amount as though no
coinsurance existed. For example,
Thomas buys a policy for $5,000 on property valued at $10,000. Even though his policy states 80 percent
coverage, since the value is so much higher than the policy, the full $5,000
will be paid without regard to coinsurance amounts.
5.
It is not necessary to fully insure with one carrier,
unless the policy disallows other insurance.
It is wise to purchase policies with uniform coinsurance clauses. Where multiple policies exist, each will pay
on a pro rata basis.
6.
If a policy with a coinsurance endorsement to insure more
than one item, it is recommended to make the clause apply to each item
separately. For example, to the
building and separately to the contents.
When this is the case the wording is typically similar to: if this
policy be divided into two or more items, the foregoing conditions apply to
each item separately.
Why would a policyholder want coinsurance?
At first glance, coinsurance clauses would seem only beneficial
to the insurers who are using them to limit their liability. While it certainly is true that coinsurance
does limit their liability, it is also beneficial to the consumer.
Although the theory behind coinsurance is applicable to any type
of coverage, fire insurance provides a clear example of how coinsurance helps
achieve rate equity and adequacy for the insured. Most fire losses are partial rather than total. Less than 2 percent of the fires result in a
total loss. More than 80 percent
produce losses of less than 10 percent of the total property value. As a result only 2 percent of the time is it
actually necessary to fully insure a propertys actual value (of course, if you
are in that 2 percent total loss amount this argument will not seem
realistic). Typically, agents recommend
insuring 80 percent of the value. This
is a reliable approach since few people will actually loose everything. However, it would also be realistic, if one
were willing to gamble on the statistics, to only insure up to 10 percent of
the homes actual value. Most of the
time it would be adequate coverage.
The problem with this view, of course, is that those who do
experience losses greater than 10 percent of the property value would be very
unhappy if their agent had recommended such a low coverage amount. For those who do want to insure up to 80
percent, as normally done, having a coinsurance provides a rate credit. In other words, it keeps premium rates
down. Without coinsurance amounts, full
coverage would cost ten times the rate for 10 percent coverage even though the
chance of loss is not 10 times as great.
With equal rates per $100 of insurance, persons buying full coverage for
their losses would pay an inequitable premium considering the low statistics on
total losses. By utilizing coinsurance
amounts, it is possible to buy 80 percent coverage that is affordable.
There is another factor involved. When a mortgage is held it is usually required that a certain
percentage of the homes value be covered by insurance. Typically the lending institutions require
the amount of the outstanding loan be insured.
At least initially, that is nearly the full value of the property.
Coinsurance allows insurers to give a fair cost for the insurance
purchased. Coinsurance allows companies to collect premiums from all types of
people with different levels of risk tolerance while still keeping premium
costs accessible to each situation. It
is a well-known fact that few fire losses are total in cities with good fire
protection. The danger is greater in
rural areas with poor fire protection.
Even then, comparatively few fires result in a total loss. If there were
no coinsurance provisions fire coverage would be much more costly. Without the option of coinsurance, it is
likely that many people would purchase small amounts of fire protection, given
the higher cost. This might especially
be true if the homeowners were aware of these statistics. Those who had to buy nearly full coverage
because of mortgage or other contractual agreements would be unfairly penalized
with high premium rates. The companies
must still collect the same aggregate premium income to meet their claims. This fact would result in huge premiums for
those property owners who do not wish to underinsure or, because of mortgage
agreements, are forced to purchase insurance insuring the full cost. Without coinsurance, rates would be very
high.
Insurance professionals often compare premium rates with tax
rates. Each is based on factors that
should apply to all equally (although some could successfully argue that fairness
is not always an issue in either case).
Both taxes and premiums should be paid in proportion to the value of the
property. Of course, some may elect to
fully cover their property while others elect to insure only a portion. As it relates to insurance, those that elect
to gamble by only partially insuring their property should only receive claim
payments according to the same percentage if it is to be fair to those who
elect to fully insure. Just as states
and cities adopt a uniform method of assessment in levying taxes to prevent
discrimination, fire insurance must have some of the same uniform factors of
assessment. There must be some effort
to prevent discrimination between those who fully insure and those who only
partially insure their property.
Rates of premium are the result of many factors, including the
type of building construction (wood, brick, and so forth), types of fire
prevention available, and existing hazards.
Insurance factors are governed by the laws of averages. Given like situations, comparing losses to
premium allows insuring companies to arrive at a cost that covers claims and
still allows them to stay in business.
Small versus large property owners
There are many types of property owners from those that own a small
home to those who own large industrial and mercantile corporations. Coinsurance protects the small owners from
the efforts of large industrial and mercantile corporations to pay less for
their coverage. Dont
misunderstand. Industrial and mercantile
corporations are not necessarily trying to put their portion onto someone
else. They merely try to keep their
insurance costs down in whatever manner is available to them. The result would still be, however, unfair
to small owners if coinsurance were not part of the policies.
Corporations often have different situations than would small
property owners. The property is likely
to be located in different localities than would single dwellings, contents may
be in different locations than the main home office, even within the same
building contents may be stored in different compartments with fireproof walls
separating them, or contents may be protected from fire in some manner not
commonly used by the small property owner.
Because of these conditions, a total loss would be unusual. Therefore, Corporations may try to insure
differently than would a small property owner.
To prevent large owners from buying full protection on numerous items of
property simply by taking out a policy equal in value to the most valuable
item, insurance companies require that a blanket policy include at least 90
percent coinsurance and, in some cases, even 100 percent.
Coinsurance History
Some countries, understanding the financial advantages of
coinsurance, have actually made the practice a matter of law. France, Italy, Spain, Belgium, Japan, and
other countries have made the practice compulsory by law. As stated, the principle has been used in
marine insurance from very early times.
It wasnt until about 1890 that the United States made any serious
attempt to apply coinsurance to fire policies.
Even today, however, Americans do not seem to fully appreciate the
practice of using coinsurance to minimize rates.
In the early 1900s there were actually anti-coinsurance
laws. Typically, anti-coinsurance laws
exist in states that also have valued policy laws. States having anti-coinsurance laws have dwindled as the
financial advantage of coinsurance has been accepted. As of 1996, only Iowa, Missouri, and Texas still had
anti-coinsurance laws on the books for some types of policies.
Consumer Distrust
Agents are aware of one major problem with coinsurance and
deductible provisions: consumers dislike having to pay any part of a loss. Clients often do not understand coinsurance,
especially the more complicated types.
They often express a feeling of deception and fine print. Seldom does a consumer understand how
coinsurance lowers their premium rates, nor do they understand the reduction of
loss through the imposition of coinsurance.
Because of these common feelings, it is vital that the insurance agent
fully disclose anything that limits a payment for a loss. That includes both deductibles and
coinsurance. Such explanations must
always take place at the point of sale (prior to the loss). Many professionals feel a yearly reminder of
how the policy works is also vital.
Consumers typically only appreciate the insurance they have
purchased when a loss happens. If they
suffer no misfortune, consumers often feel the insurance companies have somehow
cheated them out of their premium dollars.
It is more reasonable for consumers to realize that they purchased
protection that was delivered by the insurance company. Whether or not a loss provided benefits is
not an issue. The protection was
provided.
Another consumer problem arises when inflation has changed the
value of the insurance protection they bought.
The amount of insurance may have been sufficient at the time of
purchase, but due to inflation or rising property values they find themselves
underinsured when a loss happens. The
first person blamed is usually their agent.
It is true that an agent needs to keep in touch with their clients and
suggest additional insurance when necessary, but ultimately each consumer must
be responsible as well for their financial security. Because it was such a widespread problem, the Businessowners
Program uses an amount of insurance clause
rather than coinsurance. The insured
submits annually a sworn statement of property values. The figure submitted is then covered at 90
percent and becomes the amount of insurance clause. The insurers liability is the proportion that the actual amount
of insurance carried bears to the agreed amount entered in the clause. This type of coverage is likely to be
eventually applied to other forms of insurance although its success or failure
will depend upon careful underwriting and loss adjustment. Without those two factors, competition could
produce exactly the same inequities that the coinsurance clause was designed to
eliminate.
Residential property policies do not usually have coinsurance
clauses. Policies must still keep the
amount of insurance in a reasonable relationship to the value of the property. There have been public campaigns to educate
consumers on their insurance policies, but it is not known how effective this
has been. When underwriting a policy,
there are basically two things that must be done. First, before accepting the risk, the underwriter is likely to
require some minimum percentage of insurance to value. Company policy often sets this at 75 to 80
percent, although the actual amount may vary.
Approximation of the value, to which the percentage is applied, is
obtained from the agent, from building cost indices, or from an appraisal
service organization. Second, during
the contract term, the underwriter gets some assistance from the widespread use
of the inflation guard endorsement.
Some companies use a renewal increase schedule that automatically
applies some percentage increase to all existing policies. Both methods help keep the amount of
insurance in a reasonable relationship with the property values.
Homeowner policies use a replacement cost provision that, while
not a coinsurance clause, does help to keep insurance to value relationships in
line. It helps to limit recovery if the
insured carries less than 80 percent of insurance to replacement cost.
Coinsurance variety
Coinsurance clauses vary in wording as well as in their application
in policies. Some companies use
coinsurance clauses individually, adapting them to the policy conditions, the
special needs of their clients, and the type of property being insured. Other companies may use a more standardized
form of coinsurance throughout their policies.
There may be times when a provision called the 5 percent waiver clause is used in
connection with the coinsurance clause.
While the exact wording can vary, it typically reads as follows:
In the event that the aggregate claim for any loss is both less
than $10,000 and less than 5 percent of the limit of liability for all
contributing insurance applicable to the property involved at the time such
loss occurs, no special inventory or appraisement of the undamaged property shall
be required provided that nothing herein shall be construed to waive the
application of the first paragraph of this clause (i.e., the basic coinsurance
clause limitation).
If insurance under Section I (property damage) of this policy is divided into separate limits of liability, the foregoing shall apply separately to the property covered under each such limit of liability.[1]
The 5 percent waiver clause merely waives the special inventory
or appraisal of the undamaged property.
It is not intended to waive the operation of the coinsurance clause
itself. Even so, the coinsurance clause
is usually not applied when content losses are small and a waiver of inventory
clause exists. Without knowing the
value of the insured property, the insurer may have trouble applying the
coinsurance clause.
It is actually an advantage for an insurance company to use the
waiver clause. When the insured values
are large and the loss is small, the fire policy requirement of furnishing a
complete inventory of both the damaged and the undamaged property may be a
financial burden to the client (the insured).
It is possible that the cost of the total inventory could exceed the
amount of the loss. The insured may
find that the cost of obtaining property values exceeds the amount that would
be reduced in the benefits paid under the coinsurance clause on small
losses. Dispensing with the hassle of
obtaining values may also improve customer relations.
The final provision of the 5 percent waiver clause states that if
two or more types of property are specifically covered, then the $10,000 and 5
percent applies to each type.
Deductibles
Also called waiting periods, deductibles relate to losses that
are not covered by the insurance policy.
Whether it is called a deductible or a waiting period will depend upon
the type of policy. Health policies
usually call time or losses not covered waiting periods. These deductibles can be stated as multiple
things. For example, in a long-term
care nursing home policy, the deductible applies to time not covered, such as
30 days. This means the first thirty
days of institutionalization would not be covered by the policy. Coverage would begin on the 31st
day of confinement. This can be
translated to money, however. If the
policy pays a benefit of $200 per day, then a 30 day waiting period equals a
$6,000 deductible.
Disability riders in life insurance policies often require a
six-month waiting period before benefits are payable. Of course, there are shorter waiting periods usually available
for additional premium. Some states
require a waiting period following an injury to establish eligibility for
workers compensation benefits. In some
states, compensation benefits become retroaction if the workers disability
continues beyond a stated period.
Why are deductibles used?
We know that deductibles keep premium costs down. When insurers pay less out, they can charge
less for the policies. Deductibles are based
on sound financial insurance theory.
Deductibles reduce the cost of insurance by eliminating frequent small
losses that would otherwise be covered by insurance. Deductibles also reduce morale hazards. When an individual knows they must pay the first initial cost of
a loss, they tend to be more careful.
Insurers typically see better loss experience in policies that have
deductibles.
Unfortunately, not all deductibles discourage carelessness or
loss experience. Franchise deductibles
may actually encourage losses in the form of exaggerated claims. By exaggerating the claim amount, the
insured may try to collect the entire loss.
Disappearing deductibles suffer the same results.
Insurance agents often try to minimize or eliminate deductibles
for their clients. Unfortunately they,
or their clients, may believe that deductibles are bad. Agents often consider them bad public
relations. Clients often believe that
insurance should cover every loss from beginning to end. Educated agents, who have done the math,
generally find that deductibles are in the best interest of their clients. Whether or not they are able to relay this
to their clients may be another matter.
Deductible clauses may be mandatory in some policies and optional
in others. Deductible clauses serve an
important purpose in insurance. Some
insurers use these clauses to eliminate coverage for small losses. Whether required or optional, the clauses
often provide a choice of deductible amounts.
Straight
Deductibles:
This is the type of deductible clause commonly used. It is often found in automobile collision
coverage. The deductible amount is
usually expressed as a dollar figure, such as $100 or $250. The actual amount may vary from $50 up.
Most consumers are familiar with the straight deductible. In automobile insurance, if Jimmy Jones
wrecks his car, he knows he has to pay his deductible before his auto insurance
kicks in. If his deductible is $250, he
must pay this amount before his auto policy will pay anything. This
deductible applies to every loss.
Straight deductibles are used in most medical policies. It is common have a $250 to $500 deductible
for hospitalizations. This may be per
occurrence or a calendar year deductible.
Some straight deductibles are a percentage of value rather than a
fixed dollar amount. In aviation hull
insurance, for example, a deductible of 2.5 to 10 percent of the insured value
of the plane may exist. It would apply
to all losses except those caused by fire and theft in most cases. Earthquake insurance also has a percentage
deductible based on the actual cash value of the property.
Convertible
Deductibles:
When this deductible type is used, the insured pays an initial
rate that is less than the manual rate.
If no loss happens, the insured has saved premium. If a loss does occur, he or she must pay an
additional premium for the right to collect indemnity. While the reduced rate will vary, in
automobile insurance the initial premium is usually around 50 percent of the full
cost. That would mean the insured would
have to pay an amount equal to the original premium before the insurer would
pay a claim. Once that additional
premium is paid, no additional amount would be due to collect on successive
losses.
Cumulative
and Participating Deductibles:
Although this is referred to as a deductible, it is not truly
one, as losses are paid in full after the insured has accumulated losses equal
to the premium paid. When this type of
policy is written, the insurer writes a 50-50 or cumulative and participating
deductible under which the insured pays 50 percent of the standard premium,
then assumes losses until they equal an additional 50 percent of the standard
premium. Then full coverage is
available for future losses during the life of the policy. This is different than the convertible
deductible since all losses apply toward the additional 50 percent of the
premium. In no case is the insured
required to pay an additional premium.
We sometimes see this deductible used in glass insurance.
Franchise
Deductibles:
Ocean marine insurance uses the franchise deductible. Marine policies are written with either
franchise or straight deductibles, but the franchise deductible is the most common. The franchise deductible is different from
the straight deductible in that if the loss exceeds the franchise (deductible
amount), the insurer pays the entire loss, not just the excess. If the loss is not higher than the
deductible percentage, the insurance company has no liability to cover.
Progressively
Diminishing Deductibles:
This type of deductible combines the franchise and straight
deductibles. While there may be
variations, the typical version used in automobile collision insurance plans
states that no loss less than a stipulated amount will be paid. If the loss is twice the stipulated amount,
it would be paid in full. Losses more
than the stipulated amount, but less than the maximum for full coverage, are
paid twice the amount by which the actual loss exceeds the stipulated amount
(and we wonder why the layperson finds insurance difficult to
understand!). For example, Joan has a
policy, which states the stipulated amount as $50. No loss for $50 or below would be covered. Losses of $100 or more would be paid in
full. Losses between $50 and $100 are
partially indemnified. A $60 loss is
paid at $20, which is twice the amount by which $60 exceeds $50 ($60 less $50 =
$10. $10 X 2 = $20). A $90 loss would be paid at $80 ($90 less
$50 = $40. $40 X 2 = $80), and so
forth. As the loss increases, the
deductible diminishes.
Not just automobile policies use this type of deductible. Homeowner policies also use them. No loss to which the deductible applies is
paid unless the loss exceeds the policy deductible. HO policies often use two types of deductibles. Deductible clause 1 applies only to damage
to the dwelling and to personal property in the open caused by windstorm or
hail. Deductible clause 2 adds the
deductible to losses caused by all perils other than fire and lightning. Sometimes the deductibles are at the
insureds option.
Of course, not all homeowner policies use the progressively
diminishing deductible method. They may
be replaced with a straight deductible amount, such as $100, since progressively
diminishing deductibles can work for the benefit of the insured. As an alternative to raising the rates,
insurers have switched to the straight deductible. The amount of the straight deductible ($100, $250, $500, etc.)
will affect the amount of premium charged.
Loss Limitation Clauses
Insurers may use other types of clauses to limit their losses in
fire insurance policies. Some are added
at the clients option as a means of lowering their premium, but others may be
mandatory in some circumstances.
Pro
Rata Distribution Clause:
This clause will state something similar to: This policy
shall attach in each building or location in the proportion that the value in
each bear to the value in all.
This clause distributes the insurance automatically over the multiple
items insured in proportion to their respective values. How inflation or other factors affect the
value of the insured property or items will not affect how the policy
pays. Buildings are not generally
affected by great swings in value, so how the policy pays will stay relatively stable. Because of this there is not much need of
this clause. Fluctuations are more
likely to occur with machinery, goods, and other items. Goods or machinery that is routinely moved
from one location to another can have wide value variations. In these cases, this clause is extremely
useful since it would not be practical or maybe even impossible to keep a
record of the changing values.
Clauses such as these tend to be more frequent in some policies
and rare in others. Pro Rata
Distribution clauses are often used in connection with blanket policies. Eighty percent coinsurance clauses are also
used in blanket policies. The two
clauses are a safeguard for the company and the insured (if sufficient amount
of insurance was purchased), because they are protected from the possibility of
inadvertently having insufficient protection.
The insured must still (1) make sure he or she has purchased enough
insurance to meet the necessary requirements and (2) make the insurance bear
such relation to the aggregate value as to comply with any coinsurance
requirement endorsed on the policy.[2]
Deductibles
Some types of insurance are more likely to use deductibles. Medical insurance made consumers familiar
with deductibles, but of course, many other types of coverage also use them.
A deductible clause requires the person or entity insured to bear
the first part of any loss that would be covered under their policy. Obviously, if the loss were not covered by
the policy it would not satisfy the policy deductible clause. Marine insurance was the first to use a
deductible clause, but it has been widely accepted, even by the consumer, in
most insurance lines.
Deductibles do not affect the actual insurance amount in most
cases; rather deductibles affect the claim payment. For example, a policy that has a $500 deductible would pay
nothing on a loss until the insured has paid the first $500 of the loss. If the loss were less than that $500, the
policy would not pay anything at all.
Deductible clauses are used to reduce the insurance companys liability
since they remove the smaller claims entirely and reduce the larger ones by the
amount of the policy deductible. There
can be variances in how deductible clauses work, but usually the deductible
applies to the first dollar losses. In
some policies the deductible applies to every loss, no matter how often they
occur. In others, deductibles may be an
ongoing process until the specified dollar amount has been exceeded.
Some policies have both a deductible clause and a coinsurance
clause. When this is the case, there
are two ways of handling them. The
coinsurance limit can be applied first to the loss, and the deductible amount
subtracted second. Or it can be the
other way around: the deductible amount applied first, with the coinsurance
applying second. Policies usually
specifically state which clause applies first and which applies second.
Although deductible clauses certainly are intended to limit the
insurers liability, they benefit the insured as well. As every agent knows, it is not necessarily
easy to convince a consumer that a deductible is in their best interest. All too often, consumers feel deductibles
rob them. In fact, deductibles are
instrumental in keeping insurance rates down.
Because deductibles eliminate many small claims, insurers save in two
ways: first by eliminating the claim itself, and secondly by eliminating the
administrative cost of paying the claim.
Because this saves the insurer money, they are able to keep rates lower
than would otherwise be possible.
Agents realize that most insurance policies are not intended for the
small claims. They are intended to
prevent catastrophic financial loss by paying the big claims. It is not unusual for business insurance to
have deductibles of $5,000 in order to keep premiums low (and therefore
affordable). In todays financial
climate, we are seeing business policies offering deductible amounts of even
$10,000 and higher. Large deductibles
absolutely reduce premium rates. When
deductibles are small the policyholder pays higher premium rates. This may prevent purchasing enough coverage
to handle the really big losses. Most
consumers would not suffer permanently from small losses. It is those big losses that would most
likely damage them financially. Since
the point of insurance is to transfer the most damaging losses, it makes sense
to select larger deductibles in order to afford the cost of purchasing larger
amounts of coverage.
In some cases there may be tax considerations when purchasing
insurance. Although losses are often
tax-deductible, it would be hard to imagine a person or business underinsuring
for the tax considerations. Usually tax
considerations relate to the premiums paid for coverage. Since tax laws do change and state laws
vary, it might be necessary to consult with a tax expert when premiums would be
high or the need for a type of coverage may be questionable.
Types
of deductibles
Deductible clauses do vary from contract to contract and from insurance
type to insurance type. Usually
deductible variations have characteristics that are particular to certain types
of coverage. Depending upon the policy
line, deductibles may apply to each property item, each accident, each year
(those that refer to each year are called aggregate
deductibles), each location, or other variations. Although there are multiple variations of
deductibles, they tend to fall into one of three categories:
1)
Straight: this
may be stated as a specified amount of money, a percentage of a value, a
percentage of the amount of insurance applicable, or a waiting period before
benefits may be received.
2)
Franchise: a fixed
amount or percentage of value or insurance applied. In this type, if the loss
exceeds the required amount, then the entire loss would be paid in full.
3)
Disappearing: losses
over a specified amount are paid at a rate in excess of 100 percent so that at
some level the deductible is eliminated.
As we have stated, there are costs associated with claim
payments. In addition, deductibles are
believed to reduce moral hazards (people are thought to be more careful when
their actions will affect them financially).
These two reasons alone are justification for the use of deductibles. These reasons especially apply to the
Franchise and Disappearing deductibles.
On the other hand, the franchise deductible may encourage the insured to
inflate their claims in order to receive payment from their policy. The same may be said for the disappearing
deductible.
Companies experimented with the disappearing deductible in
Homeowners programs to see if it would reduce the companys liability and keep
premiums down. After ten years it was
abandoned in most states and replaced with the straight deductible. Companies found that consumers quickly
realized how the disappearing deductible worked and began to inflate their
claims in order to force payment under their policies. Today homeowner policies tend to use the
disappearing deductible only when the specified deductible amount is quite
high.
In
closing
Insurance companies do not issue blank checks. The limitations in policies are limitations
on the amount of recovery. Policies are
written to benefit not only the consumer, but the insurance company as
well. Insurers intend to make a profit
so they use clauses that limit their liability. This is not a bad thing.
In the process of making a profit (allowing them to stay in business),
consumers pass the threat of catastrophic loss to another entity the
insurance company. Limitations on
recovery refer to (1) extent of the insurable interest; (2) actual cash value
of the loss; (3) policy limits; (4) other insurance; (5) coinsurance,
contribution and average clauses, and (6) deductibles.
A limitation
establishes the maximum amount the insurer will pay for a covered loss. As previously stated, only a covered loss
applies. Consumers often see their
policies as an adversarial situation: they consider it a case of them against
the insurance company. That is why we
hear consumers speak of the small print.
In reality, there is no so-called small print. Rather, it is a matter of consumers not understanding the
insurance they have purchased.
Additionally, many consumers believe all losses should be paid for by
their policies. They fail to realize
that it is the limitations in their policies that allow them to be affordable
so that the big losses may be covered.
Because consumers view their policies in an adversarial way, it
is very important that agents continue to remind their policyholders how their
insurance works for them. Only when
consumers understand why they want deductibles and coinsurance and other
limiting factors will they realize how to best use their policies. Certainly there have been instances when
insurance companies did attempt to minimize payable claims. That still happens today. However, deductibles and coinsurance clauses
do make sense for both the consumers and the insurers.