The Underinsured Machine Shop: A Coinsurance Penalty and a Business Income Claim
Riverton Precision Machine owns a building with a replacement cost of $2,000,000 and contents worth $500,000 at the time of loss. Its commercial property policy has a blanket limit of $1,800,000 covering building and contents, a 90% coinsurance clause, replacement cost settlement on both, and a $10,000 deductible. Business income coverage is written separately: $500,000 limit, 72-hour waiting period, actual loss sustained. A bearing overheats and a fire destroys $400,000 (replacement cost) of the building and $100,000 of contents. Production stops for 30 days; normal net income plus continuing expenses run $120,000 per month. The owner believes he has "almost full coverage" and expects a check near $500,000.
1. Calculate the property damage payment and explain each step of the coinsurance math.
Read the worked answer
Step 1 - Total insurable values (blanket basis). $2,000,000 building + $500,000 contents = $2,500,000.
Step 2 - Insurance required to avoid penalty. 90% × $2,500,000 = $2,250,000.
Step 3 - Comparison. Carried $1,800,000 ÷ Required $2,250,000 = 0.80. The insured is at 80% of the requirement and is a coinsurer for the 20% shortfall.
Step 4 - Apply the fraction to the loss. Covered loss = $400,000 + $100,000 = $500,000. Payment before deductible = 0.80 × $500,000 = $400,000.
Step 5 - Deductible. A single $10,000 deductible applies per occurrence, not per building or per item. Net property payment = $390,000.
The penalty is $100,000 - roughly the amount the owner thought he was buying. Note that because the policy is blanket, the comparison uses total values against total limit; one well-insured building cannot rescue an underinsured one forever, and many blanket forms impose a per-location maximum (margin clause) that could cut the recovery further.
Do not apply the coinsurance fraction to the deductible or to the policy limit; apply it to the loss, then subtract the deductible.
2. Compute the business income payment and explain why the coinsurance penalty does not reduce it.
Read the worked answer
Business income is a separate coverage part with its own limit and no coinsurance requirement on the business income form, so the 80% property fraction does not touch it.
Period of restoration: 30 days. Waiting period: 72 hours (3 days) - a deductible expressed in time, not dollars. The first 3 days of loss are the insured's responsibility. Compensable period: 30 − 3 = 27 days. Monthly exposure: $120,000 (net income + continuing expenses). Daily: $120,000 ÷ 30 = $4,000. Payment: 27 × $4,000 = $108,000, well within the $500,000 limit.
Points the producer should flag:
- The dollar deductible does not apply twice. Property deductibles apply to property coverage; the business income form uses its own waiting period (some forms also apply a separate BI deductible - read the declarations).
- The 72-hour waiting period is generally not deducted from the limit, and some forms allow it only once per occurrence.
- If the 30 days had excluded a longer rebuild (say 6 months), the $500,000 limit - only about 4 months of exposure - would have been exhausted mid-rebuild.
- Extra expense (temporary outsourcing, expedited shipping to keep key customers) is often the larger exposure for a machine shop and should be added.
3. The owner asks what he should change at renewal to avoid a repeat, and whether he can just raise the limit to $2,500,000. Advise him.
Read the worked answer
Raising the limit is necessary but not sufficient - the value has to be right at the time of loss, not just at renewal.
Options, in order of reliability:
- Insure to 100% of replacement cost ($2,500,000) and add an inflation guard so the limit tracks construction cost increases. At 100% of value, 90% coinsurance is automatically satisfied with a cushion.
- Agreed value endorsement - suspends the coinsurance clause entirely for the policy period in exchange for a submitted statement of values. Best fit for a stable, single-location risk; the trade-off is that the insured must report accurately and the carrier may require annual updates.
- Replacement cost reporting form - values reported monthly; the penalty is replaced by a reporting-accuracy test.
- Consider specific limits per building rather than a blanket if a margin clause could cap the per-location recovery.
Also address:
- Deductibles: a $10,000 deductible saved premium but is small relative to a $500,000 loss; not the problem here.
- Business income limit adequacy: $500,000 equals about 4 months of exposure. With long-lead-time machinery, 12 months is prudent.
- Documentation: written statement of values, annual review, and a note that actual cash value settlement on contents would have made the shortfall far worse.
Frame it as: the coinsurance clause is a contractual penalty for a valuation error, and the only defense is accurate values supported by documentation.