Ridgeway Fabrication: Coinsurance Math on a Two-Part Loss
Ridgeway Fabrication insures a single building and its business personal property under an unendorsed commercial property policy with a 90% coinsurance clause and replacement cost valuation on both coverage parts. The building limit is $900,000 and the BPP limit is $300,000. At the time of an August 12 fire, an appraisal puts the building's replacement cost at $1,200,000 and the BPP replacement cost at $400,000. The fire causes $180,000 of building damage and $120,000 of BPP damage, all measured at replacement cost. The policy carries a $5,000 deductible per occurrence. Ridgeway replaces the building and buys new stock within 120 days, satisfying the replacement cost conditions. No other coverage part, endorsement, or valuation option is implicated.
1. Determine whether the coinsurance clause applies to the building and compute the building payment.
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The clause applies - Ridgeway is a coinsurer.
Step 1 - Did the insured carry the required amount? Required = 90% × $1,200,000 replacement cost = $1,080,000. Carried = $900,000. That is $180,000 short, so a penalty applies.
Step 2 - Apply the formula. Payment = (Limit carried ÷ Limit required) × Loss = ($900,000 ÷ $1,080,000) × $180,000 = 0.8333 × $180,000 = $150,000
Step 3 - Check the ceiling. The coinsurance payment can never exceed the limit carried minus the deductible. $150,000 is well under $900,000, so no cap issue.
Step 4 - Deductible. The $5,000 applies once per occurrence, not once per coverage part. It is applied after coinsurance, to the combined payment.
Building payment: $150,000 before the single deductible is allocated. Ridgeway absorbs $30,000 of the $180,000 building loss purely as a coinsurance penalty, on top of its deductible.
2. Compute the BPP payment and the total claim payment, then state how much Ridgeway would have collected on the building if it had carried the required amount.
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BPP. Required = 90% × $400,000 = $360,000. Carried = $300,000. Payment = ($300,000 ÷ $360,000) × $120,000 = 0.8333 × $120,000 = $100,000.
Total. $150,000 building + $100,000 BPP = $250,000 Less the single $5,000 occurrence deductible = $245,000 payable.
Note the deductible is not applied twice. Applying it to each coverage part would be a $5,000 error in the insurer's favor and is the most common mistake on this type of claim. If your system allocates the deductible, allocate it pro rata ($3,000 building / $2,000 BPP) but the total must still be $245,000.
If the building limit had been $1,080,000: The ratio becomes 1.0, so the full $180,000 of building loss is payable, less its share of the deductible. Ridgeway would have collected $25,000 more on the building than the $150,000 the penalty allows. The extra premium for $180,000 of additional building limit is trivial compared with a $30,000 penalty on a single fire.
3. Ridgeway's CFO wants to cut the building limit to $700,000 to save premium. Quantify that decision and give him two alternatives that would remove the penalty risk entirely.
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The $700,000 proposal. Ratio = $700,000 ÷ $1,080,000 = 0.6481. Building payment on the same $180,000 loss = $180,000 × 0.6481 = $116,667. That is $33,333 worse than the current $150,000, and $63,333 worse than a correctly limited policy - to save a premium on roughly $200,000 of limit. The penalty scales with the loss, so a total loss is where the CFO's idea does the most damage: on a $1,200,000 total loss he would collect only the $700,000 limit while still owing the bank on a $1.2 million building.
Two clean alternatives.
- Agreed value option. The coinsurance clause is suspended for the policy term in exchange for a signed statement of values. The trade-off is that the insured must insure to the agreed value and must report values at renewal; understating values voids the option and can reduce the loss payment.
- Reported value / margin clause approach for the BPP. Monthly reporting with a margin clause (for example, 110% of reported values) ties the limit to actual fluctuating inventory, which fits a fabricator whose stock swings. It eliminates the year-end guess that produced the $300,000 BPP figure in the first place.
Also worth flagging: a blanket limit across building and BPP can absorb a shortfall in one coverage part with excess in the other, but only if the blanket limit is at least 100% of the combined values. Ridgeway's combined values are $1,600,000; a $1,200,000 blanket would still be penalized.