Author: Richard Faber Knowing and understanding the needs of clients requires you to understand the nuances of coverage and how they impact the insured’s business. Today, there is a greater bias toward simpler and safer coverage options. However, the simpler options are not always the best option for the insured. There is no one-size-fits-all solution for insuring commercial ventures. What is the correct or best fit will vary from one commercial enterprise to another. That concept applies to selecting the best real property valuation as well.
There are three basic property valuations available for real property. Those are replacement cost, actual cash value, and functional replacement cost. While all three options have their place in the industry, replacement cost is the most common, probably rightfully so. However, it is not the best option for every client.
Real Property
Perhaps basic, but I think the best way to begin this discussion is to help define what real property is. The most basic definition is a building or structure described in the policy declarations. But the Insurance Services Office (ISO) goes on to include a few more items within the definition of what a building is.
- Fixtures, including outdoor fixtures
- Permanently installed machinery and equipment
- Personal property owned by you used to maintain or service the building (including fire-extinguishing equipment, outdoor furniture, floor coverings, appliances used for refrigerating, ventilating, cooking, dishwashing, or laundering)
- Additions under construction not insured by other coverage
- Materials, equipment, supplies and temporary structures on premises if not insured by other coverage.
Confusion often arises with items 2 (fixtures) through 4 (personal property used to maintain or service the building). The confusion over those items comes with good reasons as they also fall within the description of Business Personal Property (contents). Moreover, ISO does not specifically define what permanently installed means.
Before we blame ISO for developing such a wishy-washy form, I suggest the motive is born out of a pragmatic approach and understanding there are a lot of grays rather than black and white doctrine in insuring those items. Flexibility in covering those items should reign supreme.
If the insured is a tenant, insurers usually consider the items as business personal property (contents) rather than building or real property. If the insured is also the building owner, conceivably they could choose either building or personal property coverage. For example, what constitutes “permanently attached” may be up to interpretation. Obviously, things like HVAC systems are part of the building, as is a freezer in a storage facility. But what about the CNC equipment (machines that create parts and goods by cutting, shaping and manipulating material) that bolts into the concrete floor? One could make the case that bolted into the floor makes it permanent, but if owners want to replace it with another machine, they can always unbolt it and sell it.
Either way the ISO Building and Personal Property Coverage Form (CP 00 10) will cover the property. The question is how to rate the property from a premium calculation perspective. From a premium rating perspective, the advantage would be to cover the overlapping property because building rates are almost always lower than personal property rates. This is because the damageability of personal property is significantly higher than the damageability of a building. I would include a notation on the application that you included those items in the building values to prevent any issues in the event of a loss. Should the underwriter disagree, they can always decide to rate the property in the manner they choose.
Agreed Value
Before I start talking about the three valuation options, I want to address the issue of “agreed value.” Insurers can write both replacement cost and actual cash value on an agreed value basis. Do not confuse the term “agreed value” with the notion that the policy will pay out the specified limit in event of a total loss. ISO commercial property coverage is still written on the basis that the insurer will repair or replace the damaged property with like kind and quality. “Agreed value” simply means that the insurer agrees to suspend the coinsurance requirement.
“Agreed Value” does not convert the policy into a valued policy. Some states also have valued policy laws. Moreover, each of those state laws vary from one state to the next. You should be aware of the laws in your area.
The base ISO commercial property coverage form (CP 00 10) is on an actual cash value basis subject to a specified coinsurance level. Options to convert the coverage to replacement cost with or without “agreed value” are written into the coverage form. The policy declarations page will specify replacement cost. Do not waste time searching for endorsements specifying replacement cost or agreed value; if the coverage option is already there in the policy, triggered by specifying it on the declarations page.
Like “agreed value,” market value is not an option for insuring real property. The primary reason arises from the fact that a major portion of market value arises from the value of the land which is generally not insurable. The primary purpose of a commercial property policy is to repair or replace damaged or destroyed property. In practice, it is unlikely an occurrence will destroy the land a building sits upon.
There are times when lending institutions may require an insurable value that is akin to the market value. This is because the financed amount is dependent upon the purchase price rather than the cost to repair or replace. The lender is not actually looking for coverage on a “market value” basis. Rather, they seek a limit that equals the amount of financing provided by them. Which brings us back to the three valuation methods I will discuss.
Replacement Cost
The name is self-explanatory. As the name states, the replacement cost basis provides coverage for the insurance carrier to repair or replace the damaged property with like kind or quality. If the insured’s 10,000 square foot joisted-masonry building is destroyed by a covered peril, the insurance carrier will pay (less any deductible) to build a new 10,000 square foot joisted-masonry building in the same place where the old one stood. That is if the limit the declarations page specifies is sufficient to pay for the new structure.
If the limit is only enough to build a 9,990 square foot building, then your insured may need to figure something out. There are publications and software available on the open market to assist in calculating an appropriate replacement cost value. Many insurance underwriters may be more than willing to provide an estimate or even share the value they calculate during the underwriting process.
Actual Cash Value
Actual cash value is the base valuation of the ISO property form. Policies are on actual cash value unless the insured selects (and the underwriter agrees) on the replacement cost option. Actual cash value equals replacement cost minus depreciation. That makes the policy structure seem a bit backwards as it requires the insured, with the help of the agent and/or underwriter, to first calculate replacement cost.
Actual cash value has some significant problems. Actual cash value is defined as replacement cost less depreciation. Depreciation is an accounting term and is not an insurance or construction-oriented term.
More confusing is there are multiple Generally Accepted Accounting Principles (GAAP) methods used to calculate depreciation. One is straight-line, which assumes the property loses value evenly over time. The fallacy of straight-line depreciation is different components may wear out faster than other components. A roof will wear out within 15 years, while the building's structure lasts much longer. Another permits depreciation at an accelerated rate (double declining balance) for tax advantages.
The accounting lifespan of a newly constructed building is 40 years. In reality, most buildings retain their usefulness much longer than that. Hence, the actual cash value calculated at the time of loss may not bear any resemblance to the insured’s exposure to risk.
The point is that actual cash value is a very imprecise term with an unpractical method to calculate the value. Not only does it create problems with how much the insured will collect at the time of a loss, but the imprecision will also create co-insurance problems. As an underwriter, I cannot be sure to tell a client how much a policy would pay on an actual cash value basis. Thus, I rarely recommend that option.
Functional Replacement Cost
More often than not, a commercial entity has purchased an existing structure. The buyer often decided to purchase that structure because the building met their needs and not that the building was the best solution to their needs. Hence, there are times when insuring a building for less than the replacement cost makes sense for the insured. Consider an example where a firm purchases a masonry building but would opt to rebuild with a less expensive pole barn if an occurrence destroyed the building. In that case, buying additional insurance to replace a building of like kind and quality does not make sense for the insured.
Functional replacement cost permits an insured to insure a building for less than the replacement cost but without the valuation problems created by actual cash value. Unlike replacement cost or actual cash value, functional replacement cost is a separate endorsement (CP 04 88) the underwriter will attach to the policy that replaces the valuation provisions of the main property form (CP 00 10).
The functional replacement cost endorsement (CP 04 38) also automatically waives coinsurance provisions within the policy for structures insured under the endorsement.
Summary
So which option is the best for any given client? As I said in the beginning, that will vary from one commercial client to the next. One way to evaluate which option is the most effective for a commercial client is to think about what an ideal post-loss environment will look like. We and the insured should ask the question, “If the insured had a total loss, how would they want to rebuild?”
Would they replace the building exactly as it stands today? Would they opt to replace the building with one half the size because there is a lot of wasted space? Would a metal pole barn structure work better than the old brick structure?
The insured’s vision of a post-loss environment will illuminate potential avenues to structure their commercial property coverage in a manner that is most efficient for them. That type of analysis will guide you and your client into considering options to provide most cost-effective property insurance solutions.
Originally Published: December 6, 2024
_____________________________________________________________________________________________________________________________________
Copyright © 2024, Big “I" Virtual University. All rights reserved. No part of this material may be used or reproduced in any manner without the prior written permission from Big “I" Virtual University. For further information, contact jamie.behymer@iiaba.net.