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Student Question of the Week: Coinsurance and Replacement Cost

Student: Question from Stacey C
Course:  Insurance

Student Question:

Review Question #5 (shown below) deals with Coinsurance. In the answers, it shows the coinsurance equation to be [(the insured amount/(.80 x replacement cost)] x AMOUNT INSURED.  Is it “amount insured” or “replacement cost of loss” because those amounts are different. Please provide clarification. Thanks.

Question 5:

Jill owns a home that has a market value of $500,000, a replacement value of $400,000, and an “actual cash value” for insurance purposes of $260,000. Her house burns down. She has insured the house for $300,000. As a result of the total loss, how much will her insurance pay?


Instructor Response:

Hi Stacey!

Yours is a great question and illustrates an important nuance.

Whenever a homeowner is under-insured, the amount of the reimbursable loss depends upon whether the home is partially or fully destroyed.

  1. If the home is fully destroyed as in Question #5, the loss (as measured by replacement cost) exceeds the amount insured. In this scenario, the reimbursement is calculated as “Amount of Insurance Carried divided by Amount of Insurance Required” multiplied by the Amount of Insurance Carried. To do otherwise would mean she is reimbursed for more than the amount of insurance coverage she carried. The explanation of Question #5 denotes the steps in calculating Jill’s reimbursement as follows: $281,250 – Correct! The required amount of coverage is 80% of the $400,000 replacement cost, which equals $320,000. Jill carries only $300,000 of insurance, thus she can only collect 93.75% of her insurance limit [(the insured amount ÷ (.80 x 400,000)] x $300,000 = $281,250.
  2. If the home is only partially destroyed, the reimbursement is calculated as “Amount of Insurance Carried divided by Amount of Insurance Required” multiplied by the Replacement Cost of the loss.  If Jill’s home suffered only $100,000 in fire damage, then Jill would have received $93,750 as reimbursement for the loss.

Please note two more important facets of this question:

  1. The difference between market value and replacement cost is the land.  Land theoretically cannot be destroyed.
  2. This policy was a zero deductible policy.