Coinsurance is defined as: A rating and underwriting concept that is designed to encourage an insured to purchase an amount of insurance nearly equal or equal to the full value of the property being insured.
So, if you insure a $100,000 home, there is a low probability of a total loss which explains why the premium is not also $100,000. The higher the value, the greater chance of a larger loss. The rate factor is applied to the total value. This is the reasoning behind what is commonly called the 80% (or 90% or 100%) rate. To be valid, the rate must be applied to a specified percentage of the full value. In the event of an underinsured loss, there is a coinsurance penalty.
Here’s an example:
value of building: $100,000
coinsurance clause: 80%
insurance required: $80,000 ($100,000 x .80)
amount of loss: $10,000
Scenario 1: building is insured for $87,000 so it meets the coinsurance requirement
Claim payment: $10,000 less $1,000 deductible = $9,000
Scenario 2: building is insured for $60,000 so the coinsurance penalty applies-
Formula: amount of insurance/amount required x loss
$60,000/$80,000 x $10,000 = $7500 minus $1,000 deductible = $6,500 claim payment.