The Warehouse Coinsurance Trap
Ridgeline Logistics owns a distribution warehouse with a replacement cost of $2,000,000. Its commercial property policy carries an 80% coinsurance clause, a $1,200,000 building limit, and a $10,000 deductible. In June a fire causes $400,000 of covered damage. The CFO's position is that the company “already has more than half the building insured,” and that raising the limit to $1,600,000 would be wasted premium because the likely losses are small. The broker points out that Ridgeline has $900,000 of cash reserves and that a total loss would end the business. The premium for the additional $400,000 of limit is $2,800 a year.
1. Compute the indemnity payment for the $400,000 fire loss and state how much of the loss Ridgeline actually absorbs.
Read the worked answer
Step 1 - the coinsurance requirement. 80% × $2,000,000 replacement cost = $1,600,000 required Limit carried = $1,200,000
Step 2 - the ratio. $1,200,000 ÷ $1,600,000 = 0.75
Step 3 - apply to the loss, then the deductible. $400,000 × 0.75 = $300,000 $300,000 − $10,000 deductible = $290,000 paid
What Ridgeline absorbs: $400,000 − $290,000 = $110,000, or 27.5% of a loss it thought it had insured. The deductible is only $10,000 of that; the other $100,000 is the coinsurance penalty.
The CFO's “more than half” framing is the error - coinsurance is measured against a required limit, not against the value of the building. Carrying under the requirement makes the insured a coinsurer on every loss, not just large ones.
2. Now assume the fire destroys the building entirely and the covered loss is $1,700,000. Compute the payment and compare it with what a $1,600,000 limit would have paid.
Read the worked answer
With the current limit: $1,700,000 × 0.75 = $1,275,000 - but a policy never pays more than its limit. Payment = $1,200,000 − $10,000 = $1,190,000
With a $1,600,000 limit (satisfying the 80% requirement): No penalty applies; payment = $1,700,000 − $10,000 = $1,690,000
Gap: $500,000.
The trade the CFO is making: $500,000 of uninsured exposure on a total loss, against $2,800 a year of premium. Even at a 5% chance of total loss in a given year, the expected shortfall is roughly $25,000 - about nine years of the additional premium - before considering that the shortfall is unaffordable, which is the whole reason to buy insurance.
Note also that the coinsurance penalty cannot push the payment above the limit; the limit caps it. That is why underinsurance is most dangerous precisely in the scenario the CFO dismisses.
3. Using retention-versus-transfer reasoning, advise Ridgeline on how to structure limits and deductibles. Address why the company should not simply insure the building for the $400,000 loss it just had.
Read the worked answer
Framework: insurance exists for low-frequency, high-severity events. Retain the high-frequency, low-severity ones through the deductible; transfer the ones that threaten solvency.
Applying it:
- Retain: $10,000 (or even $25,000) deductibles on property are rational with $900,000 of reserves - the company can fund them from cash flow, and higher deductibles usually produce a credit.
- Transfer: the total-loss and near-total-loss layer. A $500,000 gap against $900,000 of reserves means one fire consumes the business. This is the definition of a risk that must be transferred.
- Insure to value: under the 80% clause, the last $400,000 of limit is the cheapest coverage on the policy in effective terms, because without it every dollar of every loss is discounted by 25%.
Why not “insure the loss we had”: that is pricing coverage off a single data point. The loss history tells you the frequency of small fires; it says almost nothing about severity, which is what drives the tail. A program sized to the last claim will always be underinsured for the next one.
Conclusion: raise the limit to at least $1,600,000, and consider a full replacement-cost endorsement if the $2,000,000 figure can drift upward with construction costs.