Explain underinsurance and the implications of underinsurance?

In a Word... Co-insurance penalty. Not every property insurance policy has a co-insurance clause, but most do, and it is one of the least explained but potentially most important things policy holders should understand. The co-insurance clause is represented by a percentage - 80% or 90% are common. This percentage represents the amount of coverage you are required to carry in relation to the replacement cost of the property insured. For instance, if have a warehouse of stock worth $1,000,000 and a property insurance policy with an 80% co-insurance clause, you would need $800,000 of coverage to be compliant. The co-insurance clause only becomes relavant at the time a loss occurs. At that point the insurance adjuster must determine if you adequately insured, to the co-insurance requirement. The formula to determine co-insurance is as follows:

Coverage Carried / Coverage Required x Amount of Loss

For example, suppose you had an inventory worth $1M and only carried $500k of insurance, with a 90% co-insurance requirement. You have a devastating fire and suffer a loss to half your inventory. Co-insurance would work like this: 500,000 / 900,000 x 250,000 = 138,889

The $138,889 is the amount your insurance company is obligated to pay you. Does seem like craziness? You paid for $500,000 of coverage any only got $138,000? Let me further explain.... Believe it or not, the purpose of co-insurance is to keep things fair for the insurance company. Most consumers and business owners know that the odds of them ever having total loss - that is the entire sum of their property destoyed - is extremely low. Many insured only want to buy enough coverage for what they perceive is their average potential claim. The problem is, they also want the policy to provide coverage on a replacement cost basis.

Insurance companies, for their part want to insure the property for its entire replacement cost - for real estate this is the cost to rebuild the structure; for stock or personal property it is the cost to replace old with new. The purpose of property insurance is to protect the policy holder from the possibility of a complete and total loss. Co-insurance is an in-elegant way of forcing policy holders to insure their stuff for its full replacement value in the event of that total loss occuring. Now, what if you don't want to insure your stuff for replacement value? No problem, just buy a policy that pays on actual cash value basis. Or, find a policy with no co-insurance clause built in (expect to pay more). Or, use something called "blanket" insurance to eliminate the possibity of a co-insurance penalty. Don't let all this scare you though. In the real world of claims adjusting, co-insurance doesn't come up all that often. Policies often have clauses built in to accomodate seasonal fluctations of inventory values. Buildings are typically inspected to determine an estimated replacement cost. However, as the policy holder it is still your responsibility to ensure the policy coverage limit is appropriate to prevent a co-insurance penalty.