Insurance Proceeds: Use Them Or Lose Them

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When it comes to some property insurance proceeds, the tag line is: “Use it or lose it.” Most agreements such as leases and mortgages, even poorly written ones, call for one party or the other (or both) to carry property insurance for “replacement cost.” [By the way, “full replacement cost” isn’t one barleycorn larger than plain, old “replacement cost.” A full quart of milk takes up no more space than a lowly quart of milk. And, it isn’t “replacement value,” it is “replacement cost.”] But, “replacement cost” doesn’t mean that the insurer goes out and writes a check for what is determined to be the damaged property’s replacement cost, even if the property is totally destroyed. The insured only gets paid for the cost of what is actually repaired. Note that we’ve just written “repaired,” not “replaced,” even though the coverage is called “replacement” cost. That’s because “replacement cost” is a limit, not the amount that is going to be written on the check.

The most common form of commercial property insurance policy is the one published by the Insurance Services Office, Inc. (ISO) as its form CP 00 10 10 12 includes the following text:

d. We will not pay on a replacement cost basis for any loss or damage:

(1) Until the lost or damaged property is actually repaired or replaced; and

(2)  Unless   the   repair   or   replacement   is   made as soon as reasonably possible after the loss or damage.  With respect to tenants’ improvements and betterments, the following also apply:

(3)  If the conditions in d.(1) and d.(2)above are   not   met,   the   value   of   tenants’   improvements  and  betterments  will  be  determined   as   a   proportion   of   your   original    cost,    as    set    forth    in    the    Valuation     Loss     Condition     of     this     Coverage Form; and

(4) We  will  not  pay  for  loss  or  damage  to  tenants’  improvements  and  betterments  if others pay for repairs or replacement.

e. We will not pay more for loss or damage on a replacement cost basis than the least of (1), (2) or (3), subject to f. below:

(1) The Limit of Insurance applicable to the lost or damaged property;

(2) The cost to replace the lost or damaged property with other property:

(a) Of comparable material and quality; and

(b) Used for the same purpose; or

(3) The   amount   actually   spent   that   is   necessary to repair or replace the lost or damaged property.  If a building is rebuilt at a new premises, the cost  described  in  e.(2)  above  is  limited  to  the  cost  which  would  have  been  incurred  if  the  building  had  been  rebuilt  at  the  original  premises.

There are other forms of commercial property insurance, but you can expect to see the same limitations or “conditions.” Though we’ve already wasted a lot of space to show coverage language from the most commonly seen policy form, we thought it might be helpful to show how the same “rules” are conveyed in a different policy form. So, here is such a provision:


. . .

7. Valuation.


a. Replacement Cost. If Replacement Cost is shown in the Declarations Page as applicable to Covered Property, we will determine the value of Covered Property in the event of loss or damage as follows:

(1) At Replacement Cost (without deduction for depreciation) as of the time of loss or damage…

(2) You may make a claim for loss or damage covered by this insurance on an “Actual Cash Value” basis instead of on a Replacement Cost basis. In the event you elect to have loss or damage settled on an “Actual Cash Value” basis:

(a) We will then determine the value of Covered Property on an “Actual Cash Value” basis when applying the Coinsurance Condition;

(b) You may still make a claim on a Replacement Cost basis if you notify us of your intent to do so…

(3) We will not pay on a Replacement Cost basis for any loss or damage:

(a) Until the lost or damaged property is actually repaired or replaced; and

(b) Unless the repairs or replacement are made as soon as reasonably possible after the loss or damage.

(4) We will not pay more for loss or damage on a Replacement Cost basis than the least of:

(a) The Limit of Insurance applicable to the lost or damaged property;

(b) The cost to replace “on the same premises” the lost or damaged property;

1) Of comparable material and quality; and

2) Used for the same purpose; or

(c) The amount you actually spend that is necessary to repair or replace the lost or damaged property.

The term “on the same premises” is a limitation on the amount of loss or damage we will pay. It does not require you to replace lost or damaged property at the same site.

This “second” provision is the one that recently faced a Washington Court of Appeals as it looked at a coverage dispute between a church and its insurance carrier. Basically, after the church experienced a significant fire, it could collect the “actual cash value” (ACV) of the church building whether it chose to rebuild or not. In the alternative, because it had paid for replacement cost coverage, it could collect the building’s “replacement cost valuation” (RCV), i.e., the cost to return the church to what existed before the fire, but only if it undertook the restoration work. In each case, however, these, ACV or RCV, were the “limits” of coverage, not necessarily the amount to be written on a check.

So, with apologies, we’re embedding some more, dry, boring information:

[Actual Cash Value (ACV) [i]n property and auto physical damage insurance, [is] one of several possible methods of establishing the value of insured property to determine the amount the insurer will pay in the event of loss. ACV is typically calculated one of three ways: (1) the cost to repair or replace the damaged property, minus depreciation; (2) the damaged property’s “fair market value”; or (3) using the “broad evidence rule,” which calls for considering all relevant evidence of the value of the damaged property. [Source:]

[Replacement Cost Value (RCV) is a] property insurance term that refers to one of the two primary valuation methods for establishing the value of insured property for purposes of determining the amount the insurer will pay in the event of loss. (The other primary valuation method is actual cash value (ACV).) It is usually defined in the policy as the cost to replace the damaged property with materials of like kind and quality, without any deduction for depreciation. [Source:]

In our experience, ACV is usually about 70% of the RCV for the same property. That translates to a common assumption: a used building has experienced about 30% physical depreciation. That’s not the same as the “depreciation” on the books or for tax purposes; instead, it reflects wear and tear and obsolescence.

The Washington state court’s decision illuminates how replacement cost coverage works. The estimated cost to “replicate the church building as it existed before the fire” was “$729,106.42. The estimated actual cost value for the building was $593,361.66. That meant the church could have chosen to bulldoze the building and walk away, yet get a check for a little under $600,000. With that being the case, the insurer wrote a check for the actual cash value and was willing to pay up to the approximately $136,000 difference if and when the building was repaired. The church chose to repair the building.

An issue arose with respect to the building’s arched “glulam” beams. “Glulam” is a shorter way of saying “glued laminated lumber.” The problem was that to replace the damaged beams would require removing the church’s roof, whereas the less-desirable alternative, repair, did not. Church officials were loath to have the building’s roof removed. Further, four bidding contractors didn’t feel that replacement was needed. Nonetheless, the public adjuster hired by the church persuaded the insurer that the beams needed to be replaced and obtained approval for a total restoration cost inclusive of such beam replacement.

The church spent at least what its insurer had approved as a total project cost, but the beams were repaired (at a lower cost), rather than replaced. Then, the church “spent” the savings on an upgraded kitchenette (effectively, converting it into a full kitchen). It also made other “upgrades.” The court described the church’s thinking as follows: “Believing it was entitled to the funds to install new glulam beams, [the church] chose to make ‘substitute expenditures’ with funds otherwise allocated for the beam replacement.

The church’s belief was wrong. Having “replacement cost” coverage doesn’t mean you get a check for “replacement cost.” Such coverage is a limit, not a liquidated payment. The approved amount is not a budget for whatever work an insured wants to have done.

The church lost in the lower court and again on appeal. You can read its argument by clicking: HERE. Though there were many, and some were creative, none were very good. Its insurance coverage didn’t pay its legal bill. So, on top of spending its parishioner’s money for unfunded upgrades, it then spent their money to pay legal fees. While we can’t be certain, it doesn’t look like it sought advice from an insurance professional or, if it did, it found the wrong one.

Basically, if you spend the money on non-covered repairs or replacements, you don’t get reimbursed. This has some implications when it comes to reaching agreement in a lease or mortgage about the application of insurance proceeds. If one party, such as a lender, is more interested in receiving the insurance proceeds and less (or not) interested in restoring the damaged property, the owner of the damaged property may be very, very unhappy. Here’s a stark example. Suppose one has a building with a replacement value of one million dollars encumbered by a $700,000 mortgage. The “actual cash value” of that building is also $700,000 (a 30% “discount” from its replacement value). The building is “totaled” and the lender elects to take the proceeds and discharge the mortgage. It will get its money because, with a total loss of a building insured for replacement value, you get at least the ACV. Now, the owner has no building and no insurance proceeds. To rebuild, it needs a construction loan and let’s assume it can get a $700,000 loan. So, it also will need $300,000 of its own.

Can the owner swing a new loan of $700,000 and rebuild in time to preserve its right to collect the additional $300,000 that its insurer will pay if and when the building is finished (or, perhaps, as the work progresses)? Under those circumstances, where the “$300,000” gap isn’t already in the bank, can the new loan be obtained, and if so, at what rate?

Insurance isn’t brain surgery, but it is a lot more complicated (some would say, “opaque”) than a lot of subjects. That’s why insurance experts were created. Find them. Use them. Public adjusters are hired to be aggressive. Their enthusiasm is a strength, but not necessarily when the insured is seeking objective advice.


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