I Paid For Replacement Cost Insurance Coverage, Where Is the Rest Of My Money?

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We were Ruminating about the reasons some people, instead of asking for “replacement cost” insurance coverage, ask for “full replacement cost” or “100% replacement cost” coverage. That made us think about the difference between a quart of milk and a full quart of milk. We don’t have any better answer than anyone else, so that was a dead-end for a Ruminations blog posting. Fortunately, those thoughts led us to today’s topic. So, our Ruminating was not for naught.

What is “replacement cost” coverage and what other kinds of property insurance coverage levels are there? We’ll start with the second question first. There are two basic ways a loss to insured property can be valued: (1) based on its replacement cost; and (2) based on its actual cash value (ACV).

Interestingly, though these alternates are long-standing, basic insurance terms, don’t search the policy for their definitions. Neither is defined in the most commonly used policy forms, those promulgated by the Insurance Services Office, Inc. (ISO), a company owned by its member insurers and employees. That allows various courts to use different definitions for each of those terms (and they do). Lucky for us, the differences are at the fringes and they don’t lead to any overlap between replacement cost coverage and actual cash value coverage, at least not to the extent that would result in choosing one over the other.

The most common definition for “replacement cost coverage,” and the core of almost all of the various definitions you’ll find in the case law is: “the cost to replace the damaged property with materials of like kind and quality, without any deduction for depreciation.”

If you apply that definition to a given property loss and then reduce the resulting figure by “depreciation,” you’ll have fulfilled the definition for actual cash value. Yes, the difference between “replacement cost” coverage and “actual cash value” coverage is that, with an actual cash value policy, if a property is damaged beyond the cost to repair it, the coverage is limited to the value of the property in its “used” condition. By way of example, with replacement cost coverage you get enough to replace a used building with a new one. With actual cash value coverage, the most you’ll get is the value of the used building just before the loss.

A particular automobile insurance company currently is running advertisements that point out the following situation. Suppose you buy a new car and on the way home it is “totaled.” The ads point out that its competitors won’t pay the price you had paid only ten minutes earlier for the car. After all, the car has depreciated. [By the way, that’s true. If it cost $50,000 to be the first owner of a new car (from a dealer), how much would you pay to be the second owner of a car with 100 miles on the odometer? The difference is “economic” depreciation.] Policies obtainable from this advertiser will pay to replace the car with a new one (“replacement cost coverage”; its competitors will pay the price of the “used” car (“actual cash value”). That illustrates the difference.

To repeat (for the last time, but this is important), the only difference between replacement cost and actual cash value is a deduction for depreciation. Both, however, are based on the current cost of replacement, not on historical costs (when the property was built or acquired), and not on book value.

We’ve been pretty cavalier about describing actual cash value (which, from this point onward, we’ll refer to as ACV). Without the constraint of needing to follow an actual definition in the insurance policy that might have actually used the word, “depreciation,” there are some courts that avoid that word and look for the physical “fair market value” of the used building or look for “all of the facts and circumstances,” often referred to as the “broad evidence rule” approach. In the end, however, although these less common definitions exist and allow a court some latitude in establishing a “value,” all of the definitions are paths to getting to the same result.

For those readers who have gotten this far and have concluded: “You are wasting our time, no one (today) buys ACV coverage, everyone buys replacement cost coverage,” please indulge us.

Though almost everyone buys commercial property insurance with replacement cost coverage, the default policy “pays” ACV. You have to affirmatively buy a Replacement Cost Endorsement. It is OPTIONAL coverage. And, when you buy it, here is what you get (at least when using ISO Form CP 00 10), providing your election shows up on the policy’s Declaration page:

3. Replacement Cost

a. Replacement Cost (without deduction for depreciation) replaces Actual Cash Value in the Valuation Loss Condition of this Coverage Form.

b. This Optional Coverage does not apply to:

(1) Personal property of others;

(2) Contents of a residence;

(3) Works of art, antiques or rare articles, including etchings, pictures, statuary, marbles, bronzes, porcelains and bric-a-brac; or

(4) “Stock,” unless the Including “Stock” option is shown in the Declarations.

Under the terms of this Replacement Cost Optional Coverage, tenants’ improvements and betterments are not considered to be the personal property of others.

c. 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, you may still make a claim for the additional coverage this Optional Coverage provides if you notify us of your intent to do so within 180 days after the loss or damage.

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 repairs 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 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, on the same premises, 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.

f. The cost of repair or replacement does not include the increased cost attributable to enforcement of or compliance with any ordinance or law regulating the construction, use or repair of any property.

Copyright, Insurance Services Office, Inc., 2011

Although we’re going to focus on Section 3.d, readers are urged to review the entire language describing what it means to get replacement cost coverage.

The reason we’ve singled out Section 3.d, the one that says the insured doesn’t get what it has paid for until the lost or damaged property is actually repaired or replaced and then still not if the repairs or replacement aren’t done as soon as reasonably possible after the loss or damage, is because those conditions take us back to ACV.

[This is a good place to talk briefly, very briefly, about cost. Replacement cost coverage is more expensive than ACV coverage. That should come as no surprise. It isn’t that the premium cost per thousand dollars of coverage is higher. It is because the replacement cost for a given property is higher than ACV (which starts with the replacement cost and then reduces it by “depreciation”). A good rule of thumb for the typical existing building is that depreciation is 30%.]

Back to the path: If you don’t rebuild, you don’t get the replacement cost of the property, you can’t get more than the insured property’s ACV. There is no requirement to rebuild. You get ACV.

In the vast majority of cases, a building’s owner needs the insurance proceeds to rebuild. If it had to build first to get “reimbursed,” there would be fewer buildings out there. The insurance industry understands that dilemma and what you see are owners beginning with a claim based on ACV (what they would get if they didn’t rebuild) and then timely notifying their carrier of intend to rebuild, at which time they can now increase their claim to cover the difference.

This policy requirement that the insured must rebuild in order to get the replacement value of the insured property can prove a little troublesome to lenders who choose to glom the insurance proceeds in a situation where there is no further consequence to the borrower if it doesn’t rebuild (e.g., a non-recourse loan). Loans are made based on the sale value of a property and that is almost always a factor of its net operating income, an item very dependent on the property’s rent roll. So, the “brick and mortar” value of a building is already going to be less than the loan amount and then there will be a further discount, say the typical 30%.

Another issue, or more appropriately, uncertainty, about ACV is that without rebuilding a property, it is speculative as to what the property’s replacement cost would be, and ACV is most often defined as “replacement cost less depreciation.” Now you have two things to fight about: the “estimated” cost to replace the property, and how much “depreciation” to apply to that number.

Astute readers might ask: “If I don’t rebuild and only get ACV, do I get a proportionate share of the premium returned to me?” Are you stupid or something? These are insurance companies – of course not.

There have been a lot of fights in the courts (very, very few in percentage terms, but numerically significant) over various attempts by carriers to avoid paying for some cost elements such as the rebuilding contractor’s profit and overhead or for “similar” versus “identical” replacements. In most cases the insured prevail. For those who craft leases, mortgages, and other documents, these nuances are of little interest. So, all we’re going to do today is leave that clue as to what we could have droned on about today. That gives us a possible, future topic. Don’t forget, however, to search the Ruminations archives for tidbits about Ordinance or Law coverage endorsements.

If we’ve let anyone believe that if you buy “replacement cost coverage,” and rebuild, you’ll get paid the building’s replacement cost, we apologize. Take a look at the ISO Conditions (Section 3.e above). You can’t get more than the greatest of the insured property’s replacement cost, the stated policy or what it actually cost to rebuild. Also, although there is no requirement to replace property at the same location, the insurer will pay no more than what it would have cost to replace the property on the same premises.

We’d be doing everyone, including ourselves, a big disservice if we didn’t describe another coverage option even though it is rarely called for in leases, mortgages or other agreements. We’re talking about the “agreed value” option. This is not coverage that “writes a check” for a previously agreed-upon amount. That’s right, taking the “agreed value” coverage option does not establish how much the insured gets paid. What it does is “suspend” the co-insurance provision in the policy until the date the “agreed value” expires. When elected, the policy’s Declaration will list an “agreed value” and the date through which that value will be effective, generally the last day of the policy’s term. (So, with each renewal, the Declaration page has to be updated).

Aside from pointing out that this coverage option doesn’t “fix” the insured’s recovery and doesn’t eliminate arguments about replacement cost, why did we toss this in at the end? We did it so that we could introduce the concept of (or limitation on recovery imposed by) “co-insurance” principles and give us yet another full topic for another day. So, for now, here is all we’re going to say. The co-insurance provision of a commercial property insurance policy limits what the carrier will pay if the face amount of the policy is too low. It is aimed at stopping someone from paying for $200,000 coverage on a building that costs $300,000 to rebuild and expecting to get up to the first $200,000 toward rebuilding with the thought in mind that total destruction is rare and that it would be an economical way to buy coverage for the much more common “small fire.”

The way the co-insurance limitation works is that if the policy’s stated amount (the “policy limit”) is less than a given percentage (most often 80%) of the replacement cost of the insured property on the date of loss, all payments will be prorated instead of being paid in full. So, if the policy limit is $1,000,000 and the insured property’s replacement cost is $2,000,000, the insurance will only cover 50% of the actual loss. A $100,000 restoration cost will yield a $50,000 check. If the policy limit in our example is $1,600,000 (the 80% level) and the cost of rebuilding is actually the $2,000,000 figure, the insured still only gets 80% because the policy limit is a limiting factor. If the policy limit were $1,800,000, the check would be for that amount (90%). If the policy limit were $3,000,000, the check would be for the replacement cost ($2,000,000). [The mathematically astute might note that the co-insurance only comes into play where there is a partial loss, and that’s a fair way to express that outcome. In the case of a total loss, the prorated replacement cost matches the already existing recovery limit – the policy amount.]



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