I confess:  I sometimes wonder whether some claims personnel have ever heard of the “red face” test.  In other words, you should only take a negotiating position if it doesn’t actually cause you to blush.  Otherwise, how could seemingly rational people contend that buying “expanded” coverage means that the policyholder has no coverage?  (And how do they get some judges to agree with them?)

Let me explain, in the context of the oft-misunderstood coinsurance penalty contained in most property insurance policies.  Coinsurance is a type of “fine” that the carrier  imposes on the policyholder for under-insuring the value of tangible property or business income. The penalty is based on a percentage stated within the policy and the amount under-reported.  The most common penalty is 80%, but it can be as high as 100%.  

As an example: A building actually valued at $1,000,000 is insured for only $750,000 under a policy containing an 80% coinsurance clause. Since the building’s insured value is less than 80% of its actual value, when a loss happens, the claim payment will be subject to the underreporting penalty. If the policyholder suffers a $200,000 loss, the policyholder will recover $750,000 ÷ (.80 × 1,000,000) × 200,000 = $187,500 (less any deductible).  So, in this example, the underreporting penalty would be $12,500.  You can see why accurately reporting property values to the carrier is important.

Now let’s look at an actual case involving coinsurance.  Buddy Bean Lumber Company (no I’m not making the name up) operates a lumberyard in Arkansas (of course).  Someone stole a supply of valuable electrical wire from Buddy Bean’s lumberyard.  Buddy Bean filed a claim with its carrier, Axis, asking to recover the actual cash value of the wire.

With respect to this particular claim, the Axis policy contained a few important provisions. 

First, the policy had a 90% coinsurance provision tied to the value of Buddy Bean’s saw and planing mills, which stated:  “Axis will not pay the full amount of the loss if the value of Covered Property at the time of loss times the Coinsurance percentage shown for it in the Declarations is greater than the Limit of Insurance for the property.”  The policy defined “value of Covered Property” as the property’s “actual cash value as of the time of the loss or damage.” 

Second, for an additional premium, Axis sold Buddy Bean “optional replacement cost coverage” that allowed Buddy Bean to choose whether to file a claim on an actual cash value basis or on a replacement cost basis.

The stolen wire had an actual cash value of $725,000, but Axis refused to pay that amount, arguing that the claim was subject to a huge coinsurance penalty.  According to Axis, the value of the saw and planing mills for purposes of the coinsurance provision should not be measured by actual cash value ($4,050,000) but instead by replacement cost ($21,024,000).  The Axis theory:  The effect of Buddy Bean’s buying optional replacement cost coverage was the substitution of “replacement cost” for “actual cash value” in the coinsurance provision. Since the policy limit for the mills was only $3,837,500, way short of the replacement cost of the mills, Axis argued that Buddy Bean had failed to buy adequate insurance.

Buddy Bean, on the other hand, argued that it had the right under the policy to choose to have the claim processed on an actual cash value basis, meaning that the mills should be valued at actual cash value for purposes of the coinsurance provision.  Hence, no penalty.

What’s amazing to me is that the district court agreed with Axis, holding that “the policy language was unambiguous and…the value of the mills should be measured by their replacement cost because Buddy Bean had purchased replacement cost coverage, thereby changing the definition of ‘value’ in the coinsurance provision.”  (Um, judge, what about the fact that Buddy Bean retained the option to file claims on a cash value basis?  Court:  Don’t bother me with details!)

I suppose this is why the Lord invented appeals courts.  The Eighth Circuit (properly) reversed, writing: “The proper interpretation of the coinsurance provision depends on whether the insured has filed an actual cash value or a replacement cost claim.   Here, Buddy Bean filed a claim with Axis for the actual cash value of its stolen wire.  In order to calculate whether Buddy Bean is subject to a coinsurance penalty on that claim, the term ‘value’ in the coinsurance provision should be read as the actual cash value of Buddy Bean’s saw and planing mills…Contracts of insurance should receive a practical, reasonable and fair interpretation consonant with the apparent object and intent of the parties…Buddy Bean’s choice to purchase a type of expanded coverage was not intended to vitiate its basic coverage…If Buddy Bean’s decision to buy replacement cost coverage would automatically change how to calculate the coinsurance provision, the insured would always suffer a substantial coinsurance penalty even on actual cash value claims.”

What would the Axis claims person say about all this?  Probably what Robert DeNiro’s (character’s) kid said in “A Bronx Tale”: “Hey, I took a shot.”  In any event, if you’re buying replacement cost coverage, check the coinsurance provisions very carefully.  

You can read the full Buddy Bean decision by clicking here.