In order for an insurance policy to be put into effect there has to be the potential for loss, and the payment of loss should only put you back in same financial conditions you were in prior to the loss. Homeowner insurance is not a way to increase your net worth by replacing lost items with items of greater value.
In theory, an insured would only want to carry insurance equal to their exposure to loss because no one would want to pay more than he should. However, since neither the insured or the insurer know what portion of the insured structure is going to be damaged, the insurance company takes upon itself 100% of the potential loss and collects appropriate premium to cover the potential loss. A compromise recognizing these two issues is the use of co-insurance. The concept of co-insurance recognizes the notion that most physical damage perils will only cause damage to a certain percentage of the insured property, so only that portion should have to be insured.
Most homeowner policies of a replacement cost basis have the requirement that the insured will keep the insurance value on their home to at least 80% of the replacement cost; and if they do, the insurance company will pay 100% of replacement at the time of loss. If at the time of loss the homeowner has allowed insurance to drop below 80%, then the claim will be based upon the percentage of coverage to the replacement cost. An example may help.
The insured has a home valued at replacement value of $100,000. If insured keeps insurance value at $100,000 and has a total loss, the $100,000 is paid. If the insured has allowed the insurance to drop to $80,000 and have a fire which totals the home to the $100,000 only $80,000 will be paid since $80,000 is 80% of total value. The risk of under insuring is evident in this example. The insured will have to make up the difference on his own.
If the insured were to have a partial loss up to $20,000, since again the $80,000 is 80% of replacement, the full $20,000 would be paid. However, if the home were to remain at $100,000 and the insured allowed the insurance to drop to $50,000, which is only 50% of replacement, and the home is totaled, only $50,000 would be paid. In the scenario of a partial loss of $20,000 only $10,000 would be paid.
The function of co-insurance then is to allow the insured to pay for only a share of a total loss and for the insurer to collect premium commensurate to the risk. It also has a benefit that the insurance company will not take depreciation at time of loss when insured maintains at least the 80% provision.
In writing insurance for commercial buildings, co-insurance is used to incentify the insured to keep the building close to 100% of value by giving insurance premium breaks at the initial writing. The rate per $1000 of value would be lower for an insured covering a building to 100% as compared with insured only insuring the building to 75% of value. Again, claims would be paid based on keeping proper co-insurances in place on policies.