Understanding Coinsurance in Commercial Real Estate

In commercial real estate transactions, institutional lenders always require borrowers to maintain property insurance on its property. This insurance protects the lender’s collateral in the event of casualties to the property. To prevent risk exposure, most institutional lenders do not permit insurance policies that include coinsurance. Understanding what coinsurance means and how it works is essential for both borrowers and lenders.

What is Coinsurance?

Coinsurance refers to a shared risk between a borrower and an insurance company. In commercial real estate, coinsurance requires borrowers to insure its property for a specified percentage of its replacement cost— usually 80%, 90%, or even 100%. If a borrower insures its property for less than this required amount, the borrower risks not receiving enough compensation to fully restore the property in the event of a casualty. If a borrower is willing to take on the risk associated with coinsurance, namely, the coinsurance penalty and lower policy limits, the borrower will receive a more attractive premium. However, since coinsurance primarily hurts borrowers, a borrower can try to waive coinsurance when negotiating with its insurance carrier. If a coinsurance clause is waived, the borrower should expect to pay higher insurance premiums for the policy, since greater liability is placed on the insurance company.

Here’s how the coinsurance clause works:

1. If a borrower maintains the adequate replacement cost of coverage, and a casualty occurs, the insurance company should cover the full amount of the damage (up to policy limits); and

2. If the borrower is underinsured, meaning they insure the property for less than the full replacement cost, coinsurance applies, and the borrower is subject to the coinsurance penalty and will receive a reduced payout based on a formula. The borrower will need to come out of pocket to cover the remaining cost of reconstruction, again presenting the possibility of not fully restoring the property or a loan default.

Coinsurance Formula

The formula for calculating the payout (when coinsurance applies) is as follows: [(Amount of insurance carried / Amount of insurance required) – deductible] x Loss amount = Payout

For example: If the property is worth $2 million and the coinsurance requirement is 80%, the borrower should insure the property for at least $1,600,000.00. Assume there is no deductible for purposes of this illustration.

However, if the borrower only insures the property for $1,400,000.00 and a loss occurs of $100,000.00, the formula would be: ($1,400,000.00 / $1,600,000.00) – 0 x $100,000.00 = $87,500.00.

In this scenario, due to the property being underinsured, the insurance company would pay $87,500.00 instead of the full $100,000.00, and the borrower would be responsible for the remaining $12,500.00.

Why Coinsurance?

It is standard practice for underwriters to include coinsurance within insurance policies. Coinsurance provisions in property insurance exist mainly to ensure the insurance company receives enough premiums to cover potential claims, which helps avoid higher rates and ensures insurance remains accessible. Without coinsurance and imposed penalties for underinsurance, a policyholder might be tempted to buy less coverage and pay a smaller premium across all policies, since the probability of a substantial casualty is low. However, if too many policy holders opt for less coverage, the insurer may not collect sufficient premiums, leaving them unable to pay any claims, especially if multiple claims occur at once. To cover this shortfall, insurance companies would likely raise rates for all policy holders, potentially creating a cycle of underinsurance and rising premiums. Eventually, this cycle could make insurance unaffordable or even unavailable for property owners.