Acknowledgement: This blog is based on a post by Bill Wilson, https://insurancecommentary.com/how-to-explain-coinsurance-to-clients/.
Going back to the 19th Century, most property policies have a requirement that insurance limits be at least a stated percentage of property values. Insureds who fail to meet this requirement at the time of a loss must bear part of the loss, or in insurance terms become a “co-insurer”.
The coinsurance requirement does not have to be – and usually should not be – 100% of value. 80% or 90% of value is common to real and personal property insurance. (Since business income loss is harder to quantify, coinsurance should be 80% or less, frequently as low as 50%.)
The reason for coinsurance is that while insurance should cover a maximum possible loss, in practice most property losses are partial rather than total. If insurance prices were determined solely by insured values, property owners would be tempted to only insure a portion of total value, especially if their property is well built to withstand a total loss. By charging lower rates for higher coinsurance, insurers make it more economical to purchase higher limits. This gives them more income to pay claims, and insureds have protection against the occasional major loss.