Replacement Cost Violates Indemnification Rule

Assertion: Replacement cost violates the principle of indemnification as the insured is placed in a better position than existed immediately prior to the loss. For instance, the insured’s five-year-old production machine is destroyed by a covered cause of loss and they get a new one in its place. This is an abuse of the insurance mechanism.

Point of Fact: Replacement cost may be the truest form of property indemnification available when considered this way: the insured’s machinery is destroyed by fire, now they have no means to manufacture products and conduct business; money doesn’t necessarily do any good, they need the equipment. Same with the building, the insured needs a building to operate in, not the money.

Replacement cost is the best mechanism for returning the building and contents to the insured, regardless of the type of operation (manufacturer or office), with the only out-of-pocket expense being the deductible chosen by the insured, provided limits have been chosen correctly. This is the best demonstration of the goal, purpose and representation of indemnification.

Still, how can replacement cost embody the principle of indemnification? Why is the insured not better off than before the loss? Valid questions both which relate to the due diligence required to calculate property limits.

Insuring to Cost

Indemnification principles are not violated and are, in fact, upheld because the amount of insurance purchased is intended to equal the cost new of all eligible and insured property on the day of the loss.

To illustrate, the machinery involved in the loss exampled above cost $100,000 new five years ago; it has a current resale (market) value of $50,000; but to buy a new piece of equipment of like kind and quality cost $150,000 today. The only amount that matters when insuring on replacement cost basis is what it cost on the date of the loss; thus, the insured would insure that machine for $150,000.

The same process is applied to all real and personal property insured to develop the true value or its full replacement cost. To insure to value requires calculating the current cost to buy or build another one like it (whatever “it” is) on the date of loss.

Too often the level of calculation required to develop this amount is thumbed by the insured and even the agent. While it may not be reasonable to expect the insured or the agent to take time to calculate the cost new of every piece of machinery, equipment, furniture, stock or other covered property, this is the level of due diligence required to develop the correct replacement cost of the business personal property. Insurers certainly apply this level of diligence when investigating and settling a property loss; particularly when confirming compliance with coinsurance provisions.

Insureds, or their agents, often simply guess at the replacement cost of personal property. Guessing can create or heighten the coinsurance penalty. The coinsurance penalty and its relation to indemnification will be discussed in a future article. Insureds can hire an appraisal services to undertake this due diligence, for a fee.

Developing an accurate replacement cost for building coverage is much easier than precisely calculating the value of contents (business personal property) due largely to building cost estimators.

Cost estimators coupled with knowledge of usual and customary square footage costs within the particular locale generally produce highly accurate insurance to value figures. But even this does not guarantee the insured will be paid their idea of replacement cost (see part 3).

“Going Out Of Business”

Insureds occasionally decide not to rebuild or replace lost property following a loss and instead elect to go out of business. Property policy provisions guard against violating the principal of indemnification when this decison is made. Insureds choosing not to rebuild or return to previous operations will receive the property’s actual cash value.

The principal of indemnification remains intact because the insured gets no more than the remaining value of the insured property – the remaining use (cash) value of what they lost.

Indemnification is complete when the insured is returned to essentially the same condition that existed prior to the loss (subject to policy provisions and exclusiion). Replacement cost accomplishes this by providing the insured a fully furnished and equipped operation and no better. If the insured chooses not to reopen, they are out “nothing,” they don’t need the lost contents any more, and are essentially made whole by being paid the remaining use value (depreciated value) of what they had.

Defined Values

Three distinctly different property “values” were highlighted in the above paragraphs: actual cash value, replacement cost and market value. Two are common to insurance, and one generally has no relevance in insurance, until the government gets involved.

Actual cash value (ACV) is the initial valuation method applied in the commercial property policy. Even if the replacement cost option is chosen, some property continues to be valued at ACV. Actual cash value is defined as the cost new (replacement cost) on the date of the loss minus physical depreciation. “Physical” is highlighted because there are many different types of depreciation: depreciation due to obsolescence, accounting depreciation and economic depreciation. None of these relate to the insurance definition of depreciation. Physical depreciation results from use and ultimate wear and tear meaning that the insured does not get paid for the “used up” value of the property.

Attention must be paid to the beginning point in the calculation of ACV, the cost new on the date of the loss. ACV is not based on the value when it was purchased or at any point between that date and the date of the loss. The cost new on the date of the loss is the figure that matters. This is key when choosing limits, the insured must still calculate the cost new even if using ACV as the loss settlement option.

Replacement cost was defined above, the cost to replace new with like kind and quality on the date of the loss. There is no allowance or penalty for age, depreciation or condition. The insured must simply insure the property at what it will cost to buy or build it today.
Market value is what a willing buyer will pay a willing seller on the open market, it is not normally a value with any relationship to insurance. The rise and fall of the market value does not necessarily change the cost to rebuild a building following a loss.

Understanding that this discussion mainly revolves around commercial property, the housing market is still a good example the problem inherent to market value, and why it’s not a good value for insurance purposes. Residential real estate markets have seen steep declines over the last several months. Census department statistics report that the average market value of a home fell 11.2 percent from March 2007 to March 2008; and statistics published by the National Association of Realtors showed a 7.68 percent decrease in housing prices in 2007. Does this mean that the cost to rebuild a particular house has changed? No! It simply indicates that the person could not sell it for as much as they could a year ago. However, it would still cost the same or even more to rebuild the house if it burned down.

Market value has nothing necessarily to do with insurance value, except in ordinance or law issues and flood coverage (both of which will be discussed in future articles).

Some of the twists and turns in property values, along with the problems governments bring to property values will be detailed in upcoming property value articles. Continue to check back regularly as we continue to dissect property values and what it means to your clients.