COINSURANCE IS...Coinsurance is a contractual requirement that the insured carry agreed upon insurance-to-value, as specified by a percentage (usually 80%, 90% or 100%) entry on the Declarations page. If, at the time of loss, the limit of insurance is less than the value of the property times the coinsurance percentage, the insured will become a "co-insurer," along with the insurance company, when a loss occurs. While the coinsurance clause is effectively an "penalty" for underinsuring, another way to look at it is that it's also an incentive to insure to value. You can also insure on an agreed value basis which suspends the coinsurance clause. This is normally done on a full insurance to value basis.
The purpose of coinsurance is not to punish an insured for carrying inadequate insurance-to-value, but rather to provide a financial incentive that:
(1) encourages them to carry adequate limits in the event of major losses, and (2) rewards them (in many instances) with a significant premium reduction for doing so.
Why do insureds need an incentive to carry limits of insurance approaching the value of their property? Simple...because, in the aggregate, most losses are partial and don't result in a total, or even substantial, loss. Without a financial incentive, insureds who are not risk aversive might be inclined to purchase relative small limits of insurance. Since that inclination depends, in part, on the structure and occupancy of the building, the amount of the incentive is largely determined by those factors.
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