In a previous blog, we discussed the concepts of Actual Cash Value (ACV) and Replacement Costs (RC). While the concepts are somewhat straight forward, their application to actual losses continue to have issues.
In an ACV settlement, determining RC is relatively straight
forward. Regardless of the age or
condition of the damaged property, find a new object of like kind and quality
and RC is established. The difficult
comes in establishing the amount of depreciation that reflects the age, wear
and tear, and general condition of the damaged property. Accounts use various
methods of calculating depreciation which are designed to write off the
original cost of property over a predetermined use life. Under accounting methods of depreciation, the
value of property will reach zero or near zero, i.e., salvage value, in a
specified number of years. Practically,
a piece of property can be fully depreciated from an accounting perspective but
still be useful and, therefore, have a residual value. Depreciation from the insurance perspective
tries to determine the useful value of a piece of property at a certain point
in its life cycle. A building may be
fifty years old but still have value if it is in good condition and habitable. There are valuation services that have
depreciation charts which suggest levels of physical depreciation which are
more appropriate to insurance valuations.
However, physical depreciation can be subjective and require judgement
to be applied appropriately.
Replacement Cost (RC) which seems to be a straight forward
concept also has a few issues. First,
the term RC as used in insurance policies can be misunderstood by
policyholders. RC may suggest that the
policyholder is going to get a new building.
The proper interpretation of RC in insurance policies is getting the old
building back made from new materials.
In a previous blog, we discussed the principle of indemnity. Insurance policies are designed to put the
policyholder in a post-loss position similar to their pre-loss position. ACV would put the policyholder back in the
same value position as before the loss.
RC will put the policyholder in the same physical position as before the
loss. Since depreciated materials are
not available, RC will use new materials of like kind and quality to restore
the original property.
A second and more difficult issue with RC is how is it
determined and who should make the determination. Determining replacement cost of personal
property is less of a challenge. One can
price a new object of like kind and quality and establish the RC value. Determining the RC of real property is a
different animal. There are several
issues that over time may have altered the physical characteristics of a new
building over the existing building.
Building codes, types of building materials, changes in building
methods, environmental matters, accessibility requirements are just a few
externals that can affect the cost of new building. Some of these items may cost less that the
original, pre-loss items, but some may cost more. Valuation of the actual reconstruction costs
including the impact of many of these external factors can only be done by
experts in the field of construction, i.e., building contractors, engineers or
architects. A further problem is when
building codes or ordinances require features that were not in the pre-loss
building to be included in the reconstructed building. Such items could be a sprinkler system or an
elevator. The property insurance policy
is a contract of indemnity to compensate the policyholder for the loss of
covered property caused by a covered cause of loss. If features that were not covered property at
the time of the loss and were not damaged by a covered cause of loss in the
pre-loss building, then the unendorsed property insurance policy has not
contracted to pay for these features.
Typically, coverage for such features must be purchased through an
endorsement to the property insurance policy.
Some policies have begun to provide limited amounts of coverage for this
increased cost of construction as an additional coverage. However, such additional coverages may not be
adequate in every loss situation.
In the next blog, we will discuss amendments to the basic
property insurance policy that are available to more adequately deal with some
of the issues discussed above.