Insurance Academy

The Simple Reason Homeowners’ Customers Need Replacement Cost

By Patrick Wraight | April 25, 2018

I’ve been thinking a lot about homeowners’ insurance lately. That might be because I’m in the middle of the BPIC (Basic Personal Insurance Course) and the last two sessions have been focused on homeowners’ insurance. It may also be that we’re out house hunting. Cue the music, one couple, three houses, he likes one, she likes one, neither really likes the third…

Whenever I think about homeowners’ insurance, the idea of valuation comes to front of mind. I know, you’re jealous that I’m so insurance-minded (or you think that I’m a little sick). The first time I bought a house, I wondered why the insurance company was writing a policy for $250,000 when I only paid $86,000 for the house. My agent was so cool. He just looked at me and said, “Do you want us to pay the mortgage or replace your house if something happens?” Good way to put it. So, let’s talk about some ways that we can value property (specifically homeowners’ policies).

Market value

As far as insurance goes, this valuation is useless. It won’t help anyone. Why, you ask? Market value is the price that both seller and buyer find fair and reasonable. Two parties that want to trade money for real property will trade when the money makes sense compared to the property.

Market values can change wildly year over year or even month over month. Parties can look at a piece of property and (based on what other similar properties have sold for) find that they are willing to offer less, more, or exactly what’s been asked. I once bought a house and sold it less than five years later for more than 25% increased value. The next house I bought wasn’t so lucky. I bought it right before the bubble burst and in a community that wasn’t doing well economically. I’m still licking those wounds.

As far as the homeowners’ insurance goes, that’s very much why you can’t have a policy at market value. You can’t even have a policy that is set at the purchase price. Remember why we buy insurance. (Because the bank makes us? Wait, no.) It helps us to manage the risk associated with owning that property. If something happens to it, we want to be indemnified (brought back to essentially the same economic condition that we were in before the loss).

If we write a homeowners’ policy for market value (for arguments’ sake, let’s call the purchase price market value), and there is a partial loss, will that make the insured whole? Will it restore them to the same financial condition that they were in before the loss? Maybe (if we suspend coinsurance).

What if it’s a total loss? The insured would have some money for their contents and a place to stay while their mortgage gets paid off. Why would I say that? Because the mortgage company’s name is on the check and they know that there’s nowhere near enough money to rebuild the house. I can see the mortgage company looking out for their interest and then the insured is no longer indemnified. There’s no home and the insured has to go out and buy or rent a place to live.

Replacement cost value

OK, let’s dig into this idea of replacement cost. We have to use external resources because homeowners’ policies don’t define replacement cost. That means that we need a common, normal usage.

Using the glossary in “Property & Casualty Insurance Concepts Simplified,” we find this definition for replacement cost. “The cost to replace with new material of like kind and quality on the date of the loss. There is no allowance or penalty for age, depreciation or condition.” That sounds pretty simple, right? Can we simplify it more? How about this: the cost to replace one thing with another that’s as close to the same as possible.

Let’s go back to why we buy insurance. We buy it to handle the risks that we can’t finance ourselves. Since most people don’t have enough cash in the bank to rebuild their homes, and communities no longer stop everything to come together and build people’s houses, we need money available to rebuild homes after the loss occurs.

In fact, most people don’t have enough money in the bank to handle a partial loss at their homes. Consider a kitchen fire that only destroys the appliances and cabinets. That’s upwards of a $10,000 loss. Where does that money come from if not the insurance policy? Possibly nowhere, but likely a loan of some kind. That’s why we buy insurance.

If the goal of the insurance policy is to put the insured’s house back to a livable condition and to make it similar to what it was before the loss, they need replacement cost.

What if there is a total loss and the insured just doesn’t want to rebuild?

Actual cash value

The homeowners’ policy is designed to default to replacement cost coverage. The policy assumes that the insured wants to repair or rebuild the house that existed before the loss. However, it is possible that the insured just won’t want to rebuild that house in that place.

That’s where the policy’s actual cash value provision kicks in. If repairs are not going to be made, the policy just pays actual cash value. What does that mean? Well, if replacement cost is the cost to replace with like kind and quality for similar use without deduction for age, condition, etc., then actual cash value must be replacement cost with a deduction for depreciation due to age, condition, etc.

Why would someone want actual cash value? Let’s go back to our total loss situation. It may be that the insured received an offer to buy the land that the house was on and they decided to take that offer. The house is no longer going to be rebuilt and the insured is planning to buy another house. They take the check for the actual cash value of the house, pay off one mortgage and buy a house with the rest.

Why is that right? Replacement cost pays to repair or replace the house. Remember that we are putting someone in essentially the same financial condition that they were in before the loss. Since the insured does not plan to replace the house, they are out its value. Therefore, they receive payment for that value and are now restored financially.

What about actual cash value as it relates to personal property? That’s another discussion for another day. I have another house to go see and you are getting ready to change channels anyway.

About Patrick Wraight

Patrick Wraight, CIC, CRM, AU, is director of Insurance Journal's Academy of Insurance. He can be reached at pwraight@ijacademy.com.

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