During a recent storm, an insured suffered a substantial hail damage claim. After an inspection of the property, it was discovered the building was insured to 72% of its replacement cost, when, according to the coinsurance clause, it should have been insured to at least 90%. After the resulting coinsurance penalty, the insured had to pay 18% of the loss!
Choosing or verifying a building limit is an important part of issuing or renewing an insurance policy. If a loss occurs, it will be essential the limit is high enough to indemnify the insured for a loss. But with so much information on building “value” and the insured’s preconceived idea of the building’s value, how do you choose the right limit?
When choosing a limit, one should consider many factors including the valuation type, building construction, square footage, permanently-installed equipment, unique building characteristics, availability of building materials, ordinance and law, and coinsurance.
Replacement cost is the most common type of valuation. When a building is insured at replacement cost, the limit should represent the amount it would cost to repair or replace the building of the same size with the same kind and quality of materials. When determining the value, building cost guides and estimators can be used as tools and/or local builders can be contacted for professional building appraisals. The market value and tax assessment value should not be used when determining replacement cost.
If an insured would choose not rebuild if there’s a total loss, actual cash value may be an option. The actual cash value is technically the replacement cost minus depreciation. The depreciation would not necessarily be the same as that used for accounting purposes, but rather a percentage of the replacement cost that represents the useful life of the property. From a claims perspective, depending on the case law and jurisdiction, the broad evidence rule may be applied when determining the value of a building insured at actual cash value. With the broad evidence rule, the adjuster may consider the replacement cost less depreciation, the market value, and the tax value to verify the insured would not incur an economic gain or loss from the settlement of the claim.
Functional replacement cost valuation may be the best option for an insured who would not rebuild the same kind, quality, or size of building if there’s a total loss. For example, if the insured loses a brick building, but chooses to rebuild a frame building, functional replacement cost would be the appropriate valuation. When determining the proper limit for functional replacement cost, one should consider the cost to build the modified building, built-in equipment, demolition cost, and ordinances that might apply.
Aside from being less than indemnified at the time of a loss, insurance to value affects the functionality and rate making of insurance. Rates are developed with the assumption that buildings are insured to value and that the limit represents the correct amount of exposure. If a book of business is underinsured, it can result in inadequate premiums being collected for the exposure and it may appear that a higher rate is needed on the book.
This blog post was written by Amanda Paruch, Commercial Lines Underwriter II for West Bend.