Replacement cost does not mean what the client believes or has been told. Insureds assume replacement cost translates into new stuff for old junk – because agents have told them that’s how it works. Well, to be fair this is a partially true definition, but partially true definitions coupled with only partially met expectations can lead to wholly dissatisfied clients and a possible court date.
Real and personal property can have many “values,” replacement cost is only one possibility. Other values include the amount the item could bring on the open market, what an expert thinks it is worth, what it actually costs to replace or rebuild, and the value an individual places on the property. Not all of these relate to insurance or the application of insurance coverage.
Before dissecting values assignable to property and how each value relates to insurance, an understanding of the founding and guiding principal of property insurance must be established. Beginning with the earliest property policies, through the creation of the New York standard fire policy in 1918, up to and including the property insurance policies in use today; the goal of property insurance has been and remains the “indemnification” of the insured party.
Indemnification is the contractual obligation of one party (the indemnitor) to return another party (the indemnitee) to essentially the same condition (financial or otherwise) enjoyed before the loss with no improvement or betterment. Within property policies the insurer is the “indemnitor” and the “indemnitee” is the insured.
A key phrase in this definition is “…the same condition….” Insurance was not and is not designed to improve the indemnitee’s financial condition after a loss. Improvement or enrichment following a loss increases the potential for moral or morale hazards.
Traditional indemnification is a function of “the lesser of….” Historically, the most the insured (indemnitee) receives following a loss is the lesser of several amounts specified in the policy. The commercial property policy, for instance, states that the insurer’s payment options are:
- Pay the “value” of lost or damaged property;
- Pay the cost of repairing or replacing the lost or damaged property;
- Take all or any part of the property at an agreed or appraised value; or
- Repair, rebuild or replace the property with other property of like kind and quality.
“Value” is initially defined in a commercial property policy to mean “Actual Cash Value” (ACV). Actual Cash Value is the cost new less depreciation. A simplified application of ACV is a 5-year-old piece of machinery with a 10 year useful life. If this fictitious machine were destroyed by fire its ACV would be 50 percent of what a new machine would cost. If a new machine cost $100,000, the insured would be paid $50,000 provided all other conditions are met. Remember, calculation of ACV is not this simple.
Note that the definition of “value” can be changed by choosing options already available in the policy, including replacement cost or agreed value.
Since the insurance carrier has the right to choose among the four payment options, payment is generally limited to the least of these calculated amounts – unless there are laws or external circumstances that dictate the use of a different value or limit.
Broad Evidence Rule – External Circumstances
Laws in several states require all external evidence surrounding the use and value of property be considered when establishing the true value or lack of value of insured property; this is known as the Broad Evidence Rule. Application of the broad evidence rule is intended for the insured’s benefit, but it is just as likely to be detrimental to the insured.
Insured’s advantage: How does the insurer arrive at the 10 year useful life used in the ACV example above? Such calculations are usually derived from a chart, computer program or some other long-established method. Any method used is based on averages. Such chart or program probably does not take into account any specialized maintenance or upgrades done by the insured.
If the insured has performed routine plus extraordinary maintenance and/or upgrades, the example machine may actually have a useful life closer to 20 years. The insured would have only used up 1/4th of the machine’s “value” after five years. Without the application of the broad evidence rule, the insured could be out 25 percent of the value; that’s $25,000 on the example machine with a $100,000 replacement cost. The broad evidence rule coupled with ACV loss valuation would allow the insured to be paid $75,000 rather than the previous $50,000 ACV-only calculation.
Insured’s detriment: Consider a recently-purchased building where the land on which the building is located has all the value and the new owner has no need for the building. The new owner wants to tear the building down and a demolition team has been scheduled to remove the building from the premises. Due to the team’s schedule, it will be three months before tear down can begin. During that time, the owner begins removing fixtures, equipment and disconnects the power.
Because there is a loan on the property, the mortgagee requires a property insurance policy be purchased. Such policy is in full force on the day the building burns down – two weeks before slated demolition. How much does the insurer owe for this building?
Case law in some states suggests that the insurer owes nothing because the building had no use and no real value to the insured. Since it was already slated to be torn down, the owner was benefited by “free” demolition. All the evidence surrounding the building and its value, the broad evidence, suggests the building is valueless. Few would argue this building, as described, has little to no value and the insurance carrier should not be expected to enrich the property owner (we are obviously ignoring underwriting questions for sake of the example). This is the other side of the broad evidence rule.
What, then, is the definition and TRUE application of replacement cost, actual cash value, or even functional replacement cost? How does depreciation fit into insurance? Does everything depreciate? Is any of this affected by a faltering real estate market (as was seen several years ago)?
These and other property value questions are explored in more detail in the Academy’s upcoming webinar – The Reality of Property Valuation: Replacement Cost Isn’t Really. Register today, the class is Thursday, October 15.
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