Coinsurance, Replacement Cost and the Controller's Guess
Ridgeway Fabrication insures its own plant building for $600,000 on a replacement cost basis, with an 80% coinsurance clause and a $10,000 per-loss deductible. At the time of a September fire, the building's replacement cost is $1,000,000 and its actual cash value is $850,000. The fire damages a wing that would cost $200,000 to replace; depreciation on that wing is $50,000. Ridgeway's controller assumed $600,000 was "close enough to value" and never ordered an appraisal. Ridgeway carries no other property insurance on the building. The adjuster asks whether the insured intends to rebuild; the owners are undecided and want to know what they net under each choice.
1. If Ridgeway rebuilds, what does the policy pay, and why is there a penalty?
Read the worked answer
Payment: $140,000.
- Insurance required to avoid penalty = 80% × $1,000,000 replacement cost = $800,000.
- Limit carried = $600,000 → $600,000 ÷ $800,000 = 0.75.
- Covered replacement loss $200,000 × 0.75 = $150,000.
- Less the $10,000 deductible = $140,000.
Why: coinsurance is a rate credit given in exchange for insuring to at least the stated percentage of value. Below that, the insured is a coinsurer and absorbs the same proportion of every partial loss - here 25%, or $50,000 of this one. The payment is also conditioned on repair or replacement; the carrier may hold back the $50,000 of depreciation until the work is actually done.
2. What would the payment have been at an $800,000 limit, and why isn't the answer simply $200,000 minus the deductible?
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At $800,000: $190,000.
- $800,000 ÷ $800,000 = 1.00, so no penalty: $200,000 − $10,000 = $190,000.
- The extra $200,000 of limit cost relatively little premium but bought $50,000 of recovery on this loss alone.
Why the formula, not simple subtraction: the policy promises indemnity, not a windfall, and coinsurance enforces insurance-to-value. Subtracting only the deductible would let an insured carry a fraction of the exposure, pay a fraction of the premium, and still collect losses in full - the exact adverse selection coinsurance exists to prevent. The ratio applies only to partial losses; on a total loss the limit caps the payment anyway.
3. If Ridgeway takes a cash settlement and never rebuilds, what is payable?
Read the worked answer
Payment: $102,500.
- Settlement drops to actual cash value: $200,000 replacement cost − $50,000 depreciation = $150,000 ACV loss.
- The coinsurance ratio still applies to the ACV figure: $150,000 × 0.75 = $112,500.
- Less the $10,000 deductible = $102,500.
Reasoning: replacement cost settlement is a conditional promise, not an entitlement. Electing cash converts the claim to indemnity for the value actually lost. The coinsurance penalty follows the loss, not the settlement basis, so the insured cannot escape it by taking cash. Note also that some replacement cost forms settle dwellings/small buildings at ACV regardless, subject to a repair-or-replace option.