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.