In the previous blog, we discussed the values more commonly understood by property owners. So, now we must discuss the values more commonly used in property insurance policies and why they differ from the values with which property owners are more familiar.
So, what values are more relevant for insurance purposes?
A fundamental purpose of insurance is to indemnify the property owner/insured in the event of a covered loss. Indemnify, as used in insurance, generally means to restore to the pre-loss condition. This sounds good, but, as a practical matter, how do we restore one to a pre-loss condition. We cannot restore a 10-year old roof with 10-year old shingles; we cannot restore a 15-year old house with 15-year old building materials, wall paper or carpets; nor, can we restore a 5-year old automobile with 5-year old parts. And besides, insurance companies are not in the construction or auto repair business. Insurance companies are in the business of aggregating money to pay claims. To indemnify, insurance companies are obligated to pay their policyholders the money which puts the policyholder in a similar financial position as before the loss. If the damaged or destroyed property is brand-new, determining the amount of money to indemnify is relatively easy. You get enough money to buy another brand-new item. Or, if it is a new house, you get enough money to pay for new materials and labor to replace to new building that was damaged. However, if the item or property is progressing through its life cycle, i.e., somewhere between brand-new and worthless, how much money does it take to indemnify.
One would think that market value, as discussed in the previous blog post, would be the better method to determine the value of property that is not new. However, market value is not a very stable value. It can change from day to day. And until property is actually sold, market value can be somewhat theoretical. Traditionally the insurance industry’s response to this problem was the development of Actual Cash Value (ACV). It is a value primarily for insurance purposes and is not in general use outside of insurance. We all learned the formula for ACV in our pre-licensing classes. “ACV equals Replacement Cost less Depreciation.” (Interestingly few, if any, property insurance policies define Actual Cash Value or depreciation.) It was intended to provide a more stable basis to determine the value of not-new property. ACV recognizes that you cannot restore a 3-year old television with another 3-year old television. Rather you must buy a new television. But if we pay you for a new television when you lost a 3-year old television, you have been “bettered”, not indemnified. Wouldn’t it be great to get the insurance company to buy us new stuff as the old stuff wears out? Betterment can create attitudinal hazards (morale) and moral hazards which could cause the cost of insurance to go through the just replaced roof. This is where “depreciation” comes into the picture. Depreciation for insurance purposes is an attempt to recognize the degree of uses or wear and tear an item has suffered over time. Often it is described a physical depreciation as distinguished from accounting depreciation. Thus, ACV is an attempt to determine the approximate cost of a 3-year old television like yours if one was available. ACV remains in current use today in certain areas of property insurance, e. g., personal property, as a measure of indemnity. Its use can be unpopular in other areas of insurance.
When the Homeowners policies were being developed in the 1950’s in response to the explosion in home ownership after World War II, the concept of “replacement cost” (RC) was included for damage to real property. RC is a double-edged sword. It is a benefit to the property owner/insured because they do not have to pay for the cost of betterment, i.e., the difference between ACV and RC. However, it is a danger to the insurance company because it is a violation of the principle of indemnity. We are not putting the property owner/insured back in the same position as before the loss. No, we are putting the property owner/insured back in a better position than existed before the loss. This, as stated earlier, can create attitudinal (morale) or moral hazards. As the roof of the property owner/insured’s house reaches the end of it life cycle, the property owner/insured may begin to pray for a hailstorm. My son-in-law is an experienced property adjuster and he once told me how people would put golf balls in a sock and beat the shingles on the roof to simulate hail damage. (He found it curious that hail never hit anything but the shingles.) So, how does the insurance company provide betterment coverage and protect itself against adverse attitudes and costs it can create.
Simply, RC coverage required a RC valuation. If the property owner/insured wants their old roof replaced with a new roof, then they must insure for the cost of a new roof. This seems to be the concept that property owners do not quite understand. What the house is worth on the market; or what it is listed for tax values; or what they paid for it 20 years ago are irrelevant for insurance purposes. (These may have relevancy for underwriting purposes but that is beyond the scope of this discussion.) The relevant value is what it will cost for a contractor to build them a new house starting immediately after the loss. For damage to real property under RC coverage, “reconstruction cost”, i.e., replacement cost, is the crucial value. Agents must be able to clearly explain this concept to their clients. Do you want to get your house back made from new materials or would you prefer the materials depreciated due to age and condition and you pay the difference to get new materials? If only we could be Doc Martin (British TV) who tells his patients how stupid they are for not following his advice. But customer relations in the insurance business are different for us than for an idiosyncratic country doctor in England with the worst bedside manner in all of medicine.
In the next blog, we will review some of the mechanics in insurance policies that are involved with matching the property owner/insured’s expectations with insurance policy provisions.