Replacement Cost Not Always 'Replacement'

Replacement Cost Not Always 'Replacement'
Christopher J. Boggs, CPCU, ARM, ALCM
June 6, 2008


Replacement cost is optional in the commercial property policy, its use is activated by checking the right box on the application. It is, however, the "standard" valuation clause applied to eligible property in a Businessowners Policy (BOP). Even when this option is chosen, the insured does not automatically receive the item's replacement cost, as they understand it, for one of several reasons:
1) Replacement cost is not paid UNTIL the property is repaired or replaced;
2) Some types of property are limited by policy provisions and do not qualify for replacement cost, or are limited in the amount of coverage under replacement cost;
3) If the insured does a poor job calculating the limits, a coinsurance penalty could be applied; and
4) "Replacement cost" does not necessarily guarantee payment for the ultimate cost to rebuild.
Ineligible for Replacement Cost
Property not contractually eligible for replacement cost includes: personal property of others; contents of a residence (remember this is a discussion of the commercial property policy); works of art, antiques or rare articles, including etchings, pictures, statuary, marbles, bronzes, porcelains and bric-a-brac*; and "stock." Loss to items in this list is settled at actual cash value. However, the opton exists for two classes of the property listed above to be valued at replacement cost.
(*Bric-a-brac is defined in the American Heritage Dictionary and other sources as small articles, usually ornamental in nature valuable due to their antiquity, rarity, originality or sentimental nature. The term carries with it the idea of obsolescence - receiving the cost new for an obsolete article would be a violation of indemnification and the broad evidence rule. In addition to being potentially obsolete, this type of property as well as antiques, artwork, etc. may not be replaceable at any price, thus the insurance carrier is unwilling to extend replacement cost coverage to these types of articles.)
Replacement Cost Optional
Stock and personal property of others can be changed to replacement cost value rather than ACV by indicating such desire on the application. Insureds in possession of a large amount of personal property of others should consider this extension for two reasons: to avoid good will problems with clients; and to satisfy any contractual or legal requirements.
Valuing stock at replacement cost is a function of the circumstances and rarely do the circumstances necessitate the use of the replacement cost option. Stock subject to quick turnover or with very little fluctuation in value likely does not need to be valued at replacement cost as there is no real depreciation. Even products with a long shelf life or greatly fluctuating values may not require a change to replacement cost valuation. Remember, actual cash value is defined as the cost new on the date of the loss less physical depreciation; since the products are not being used, there is no physical depreciation. The insured to essentially being paid replacement cost on stock anyway. Actual cash value may provide adequate protection for stock, provided correct limits are maintained. If values fluctuate substantially from one month to the next, there are two property endorsements the insured should consider: 1) the Peak Season Limit of Insurance or 2) the Value Reporting Form (these forms are outside the scope of this discussion).
Limited Replacement Cost
Several specific types of property are valued at replacement cost, but are limited in the amount of coverage available. These classes include but are not limited to outdoor property, property off premises and outdoor signs attached to the building. Vacant property is included in this class list and coverage for these properties is severely limited.
Vacancy is defined in the commercial property policy, along with the coverage penalty appied to vacanct property. Insured's may expect to be paid replacement cost following a loss, but the policy states that any loss payment will be reduced by 15 percent, and some causes of loss otherwise covered are specifically excluded when the propterty is vacant. This policy provision needs to be clearly addressed with the client once the agent learn that an insured property is vacant.
Coinsurance - Everyone's Favorite
Coinsurance is the third barrier to the insured's receiving full replacement cost. Coinsurance was created to assure that the insurance carrier would receive adequate premium for the risk being insured. Without this penalty, an insured might be tempted to buy only a small amount of coverage on a large building because of the difference between maximum possible loss and maximum probable loss.
The maximum possible loss of any structure is the entire building; but depending on the construction and fire protection in place the maximum probable loss might be only half of the building. Without the coinsurance requirement, insureds might be tempted to purchase coverage equaling only 50 percent of the value of the building. The insured would be fully compensated for all losses falling under that amount; and statistically, most losses would fall within these parameters.
Coinsurance provisions were created to eliminate this practice and to penalize insureds that fail to adequately insure their property. In effect, violators of the provision become co-insurers of the property; they self-insure part of the loss.
Insureds failing to meet coinsurance requirements are once again subject to the problem of "lesser of." If the limits of insurance purchased do not equal or exceed the value of the insured property on the date of loss (regardless if the property policy applies ACV or replacement cost) multiplied by the coinsurance percentage shown; the insured receives the lesser of: 1) the amount of insurance purchased, or 2) the result of the coinsurance calculation, both minus the applicable deductible.
The Government Strikes Again
Jurisdictional involvement is the fourth barrier alluded to above. Insureds believe, because it is what they have been taught, that replacement cost means new for old. It does, but not when exclusions intervene.
Following a covered cause of loss, the unendorsed property policy written on a replacement cost basis will pay exactly that, the cost to replace the damaged property - but no more. This policy will pay to rebuilding the building exactly as it stood; any additional cost necessary to bring the building up to current building code will be borne by the insured.
Having to explain that to the insured is tough enough, but try explaining that the cost of tearing down the undamaged portion of the building so that the entire building can be brought up to current building code is not covered by the policy, even though the policy is written on replacement cost.
These additional costs are covered by the ordinance or law endorsement. This coverage and how it prevents an errors and omissions problem will be detailed in the next article. More property value options and definitions will be included in upcoming articles.