Author: Chris Boggs

Determining a structure's insurance replacement value (IRV) is not complicated. Very few viable methodologies are available to develop an IRV. Any complications in calculating the IRV arise only because there are multiple sources for each option. Once the methodology and source are chosen, estimating the IRV is relatively simple.

Although not complicated, developing and applying the correct IRV within the property insurance policy does not guarantee payment of the structure's entire reconstruction cost following a major loss. Key provisions within the “standard," unaltered commercial property policy (CPP) preclude payment of certain costs and expenses. The realities of “replacement cost" within the insurance policy can leave a large payment gap between the amount paid by the insurance policy and the cost to reconstruct the structure.

The unexpected results of COVID have also created a problem. Not only must the realities of replacement cost and reconstruction cost be understood, but supply chain issues have increased the cost of construction and reconstruction. The cost to reconstruct may be abnormally high for the foreseeable future.

Adjustment of a Major Property Loss

“Replacement cost" is a fundamentally misunderstood concept. Unfortunately, the insurance industry may be primarily to blame for these misconceptions.

Over time, the insurance industry and its representatives have explained replacement cost to mean new stuff in place of old stuff. While there is a grain of truth in this description, this oversimplification of replacement cost has led to an expectation that is not supported by the policy language.

Replacement cost coverage provided by the “standard," unendorsed CPP pays ONLY for the part of the structure damaged by a covered cause of loss.  Beyond providing coverage for ONLY the damaged part of the structure, the unendorsed CPP pays ONLY the amount necessary to rebuild the damaged structure back to its original condition using materials of like kind and quality (LKQ).

These two ONLYs represent the key differences between the reality of replacement cost and the expectation of reconstruction cost following a major loss to the insured structure. The CPP pays:

• ONLY to repair or rebuild the damaged part of the structure; and
• ONLY to return the damaged part to its original condition and state regardless of building codes.

A large property loss, if not total, exposes the shortcomings of replacement cost coverage. Following a major property loss, the building codes applicable to the damaged structure may disallow repair and may require the destruction of the undamaged portion of the building. None of the expense associated with the loss in value of, the demolition of and the removal of the undamaged portion is paid under a replacement cost policy.

Additionally, no building can be rebuilt out of compliance with the applicable building code. Replacement cost coverage specifically excludes any additional costs necessary to bring the building into compliance with the building code. A replacement cost policy pays only to put back what was damaged and no more.  

A March 2021 New Hampshire Supreme Court ruling serves as a prime example of the issues with replacement cost in contrast to reconstruction cost. In 101 Ocean Blvd. LLC v. Foy Insurance Group Inc., Ocean Boulevard Hotel in Hampton, N.H. obtained a $2 million replacement cost policy that provided $10,000 in ordinance or law insurance coverage.

In October 2015, a fire severely damaged the hotel. The insured was told the cost to replace the existing structure would be about $1.1 million and rebuilding it in compliance with the current building code would cost an additional $905,070. This is just slightly more than the $2 million replacement cost coverage purchased. 

The insured decided to demolish the structure rather than rebuild it. After accounting for depreciation, the insurer paid Ocean $910,141 for the structure's replacement cost, which did not include the additional cost necessary to rebuild the structure in compliance with the building code.

Although the insured had sufficient “replacement cost" coverage ($2 million), the reality of replacement cost in the unendorsed policy cost the insured (and ultimately the agent) $905,070. This is not an isolated incident; in conversations with insurance agent's errors and omissions (E&O) insurance carriers, insufficient or improper explanation of replacement cost is a common error.

“Replacement cost" does not pay what many have been led or conditioned to believe. Couple the reality of replacement cost with the fact that the requirements found in building codes have the potential to turn a partial loss into a total loss, and it becomes abundantly clear that replacement cost is insufficient following a major property loss. Reconstruction cost is the goal.

Reconstruction Cost

Rarely does a structure suffer a total loss, partial losses are statistically more likely. If the amount of damage in a partial loss situation crosses a specific threshold the building is judged to have suffered “major damage." The meaning of “major damage" varies by state and may even vary by jurisdiction within a given state.

Because there is no one countrywide definition or application of “major damage," this concept cannot be detailed in this paper; only the results of what occurs when crossing the “major damage" threshold can be described in this report.

When damage crosses the “major damage" threshold, the relevant building code official gives one of two directives regarding the undamaged portion of the building:

• The undamaged part of the structure can be repaired; or
• The undamaged part of the structure cannot be repaired and must be demolished and removed.

Regardless which directive is given, the entire structure must be brought into compliance with current building code. Replacement cost, as has been demonstrated, does not pay these necessitated additional costs.

Achieving reconstruction cost requires endorsements be attached to the commercial property policy. Specifically, Ordinance or Law coverage should be attached to every commercial property policy.

Ordinance or law coverage is the primary step (not the only step) towards turning a “replacement cost" policy into “reconstruction cost" coverage. The CPP and the Ordinance or Law coverage dovetail following a “major loss" to get closer to accomplishing reconstruction cost. Following is an example demonstrating how these coverages work towards reconstruction cost.​

Note that this is a partial loss that may become a total loss based on the application of the current building code. The jurisdictional building code official's directive will likely turn this into a total loss by requiring the entire building be brought into compliance with the current building code. Which policy/endorsement pays which part of the loss?

Lacking ordinance or law coverage, the only payment owed by a replacement cost policy is the amount in blue. The ordinance or law policy pays the amounts in red and green. Reconstruction cost can be achieved only when all costs are covered by the CPP coupled the necessary Ordinance or Law and other endorsements.

Ordinance or Law Coverage

“Standard" Ordinance or Law endorsements (such as the CP 04 05 promulgated by Insurance Services Office (ISO)) contains three coverage parts:

• Coverage A pays the value of the undamaged portion of the building;
• Coverage B pays the amount necessary to tear down and remove the debris of the undamaged portion of the building; and
• Coverage C pays the increased cost to bring the entire building (damaged and undamaged) into compliance with the current building code.

Coverages A and B focus on and pay for the undamaged part of the building for one key reason – the property policy pays replacement cost to cover only those costs associated with the damaged part of the building. Only by endorsing these coverage parts onto the policy are these expenses covered.

Coverage C applies to the entire building, damaged and undamaged. For the damaged portion of the building, Coverage C pays the difference between replacement cost and the cost to rebuild in compliance with the current building code. For the undamaged section of the structure, Coverage C pays the difference between Coverage A and the cost to bring that part of the building into compliance with building codes.

Proprietary ordinance or law endorsements may apply different coverage parts. Rather than “Coverage A," the policy may simply state, “Value of the Undamaged Portion." Regardless how delineated, ordinance or law coverage generally provides these three coverage parts.

Cost of Ordinance or Law Coverage

When ordinance or law is endorsed onto a commercial property policy, as is common with all endorsements, an additional premium is required. The relative “cost" of an ordinance or law endorsement is low compared to the out-of-pocket costs that may be suffered when it is not present. 

• Coverage for the Value of the Undamaged Portion increases the building part of the property premium about 15%.
• The same rate applicable to the building coverage applies to Coverages B and C (debris removal and increased cost of construction).

Let's apply these costs to the building in the New Hampshire case briefed above. Because assumptions must be made regarding construction and protection to estimate a rate, for this example, the estimated rate is $0.50 per $100. The resulting premium at this rate is $10,000 for $2 million or replacement cost coverage.

• Value of the undamaged portion increases the premium approximately $1,500.
• The cost for debris removal of the undamaged portion applies the building rate to the limit chosen. A coverage amount must be assumed to estimate the premium. For this example, this limit is assumed to be $100,000. The additional premium for this limit is $500.
• The increased cost of construction (remember, this is applicable to the entire building) is estimated in this example at $500,000. For this amount of coverage, the additional cost is approximately $2,500.

Total additional premium for this over simplified example is estimated to be $4,500. In the New Hampshire sample case, this $4,500 would have purchased the necessary $900,000 of required additional coverage.

Developing Ordinance or Law Coverage Limits

Value of the undamaged portion of the structure is the easiest limit to estimate because in standard ordinance or law endorsements, no estimation is necessary. The working of this coverage part (Coverage A in the ISO endorsement) states that this part pays the difference between the amount of damage and the coverage on the building. This is logical because there is no way to estimate how much will or will not be damaged so the limit must be able to fluctuate.

Removal of the undamaged portion of the building is somewhat more complex to estimate for the same reason the value of the undamaged portion does not have to be estimated. There is no way to know before a loss how much will be damaged and how much of the building won't be damaged. This is a pure estimate. A safe estimate may be between 5% and 10% of the building's IRV.

Where removal of the undamaged portion is a guess, developing the limit for the increased cost of construction (Coverage C) is an estimate of irreducible complexity. There is no “standard" or proven way to calculate the necessary limit. Only a best-guess estimate is possible. The estimation is a function of the age and condition of the building coupled with the changes in building codes over time. 

Although estimating the increased cost of construction is complex, some methodology must be behind the best guess estimate. One explainable method addresses age, condition and code changes applying a type of “dollar cost averaging" to developing the limit. Following is a reasonable and explainable methodology for developing an increased cost of construction limit.

1. Choose a percentage of building value based on the age band;
   
2. Multiply the applicable percentage by the value of the building; and
3. Multiply the answer in “2." by the age of the building.

Example: 20-yr-old building valued at $1 million applying the 2% per year cost average.

($1,000,000 * .02) * 20 = $400,000 Coverage C Limit

The applicable age bands are:

• 0-10 years: 1%
• 11-20 years: 2%
• 21-30 years: 3%
• 31-40 years: 4%
• 41-50 years: 5%
• 51+ years: 6% 

Rather than choosing individual limits for removal (Coverage B) and increased cost of construction (Coverage C), the better choice is to combine these two coverages under one limit. This way if one is less than anticipated and the other is more costly than anticipated, the limits can be used for either expense.

Reconstruction Cost – Beyond Ordinance or Law

Ordinance or law is the primary method for “guaranteeing" (as much as possible) reconstruction cost. As a disclaimer, full reconstruction cost can never be guaranteed, but applying the proper methodologies and coverages allows the insured to get as close as possible.

Other coverage options often necessary to accomplish the goal of reconstruction cost include:

• 100% insurance to value (ITV);
• Replacement cost;
• Blanket limits; and
• Inflation guard protection.

Insurance to Value (ITV)

A provision within the CPP allows the insured to purchase less than the property's 100% replacement cost to be fully insured for partial losses. The coinsurance provision allows the insured to carry 80% of the total insurable value and still be fully covered for any loss less than the limit carried.

As is evident, the gap in this allowance is that the insured is not fully protected if the loss exceeds the limit of coverage purchased. The maximum paid by the insurance carrier is the policy limits carried. If the insured purchases limits less than the 100% insurable value, reconstruction cost cannot be obtained.

Replacement Cost

Two valuation methods are common to insurance: 1) actual cash value; and 2) replacement cost. Actual cash value, in simplest terms, is the remaining life value of the property. Replacement cost, as the term suggests, does not consider the “used up" value, it values the property based on what a new piece of property would cost.

Blanket Limits

When protection is provided on a blanket limit basis, one limit applies to multiple properties, multiple types of properties or a combination of the two. For instance, a blanket limit can apply to:

• Multiple buildings;
• Business personal property (contents) located within multiple buildings;
• Combined values of real and personal property in one building; or
• Combined values of real and personal property across multiple buildings.

The advantage of blanket limits is that the entire limit is theoretically available for any one loss. If coverage for real property (the building) is miscalculated and too low, the difference may be made up by the remaining blanket amount. Obviously, the advantage of blanket limits is reduced when multiple properties or multiple types of property included in the blanket limit are damaged in one loss.

However, there is a potential limitation to blanket limits that must be considered – the Margin Clause.

Insurance Services Office (ISO) introduced the Margin Clause in 2007. More specifically known as, Limitation on Loss Settlement-Blanket Insurance (Margin Clause), the endorsement limits the payout for any one property or property type to a specific percentage of the limit provided by the insured in a statement of values for that building or business personal property. ISO's available options are:

• 105%
• 110%
• 120%
• 130%

The percentage is applied to the insurance value in the statement of values to develop the maximum payment for that particular property. Applying this limitation takes away the ability to use the entire limit for any one loss.

For instance, if the property covers three buildings as follows:

• Building 1: $200,000
• Building 2: $250,000
• Building 3: $100,000

The blanket limit is $550,000. Applying traditional blanket limits, this total is available for any covered loss to any one of these three buildings.

If Building 1 suffered a total loss and the actual replacement cost was $300,000, the entire loss would be covered by the blanket limit.

However, if a margin clause is attached that applies the 120% option, the maximum available to any one building is:

• Building 1: $240,000
• Building 2: $300,000
• Building 3: $120,000

(Obviously, if all three are destroyed in the same event, the maximum paid is the policy limit.)

Because of the margin clause, if Building 1 suffered a total loss requiring $300,000 to replace, the maximum the policy would pay is $240,000. The insured would be out of pocket $60,000 due to the margin clause.

If the carrier requires attachment of a margin clause, the highest allowable percentage should be used. Interestingly, use of a margin clause does lower the premium attributable to blanket coverage.

Inflation Guard Option

Unexpected events can increase the cost of reconstruction during the policy period. Higher than expected building costs, a natural disaster, a disruption in the construction material supply chain, an increase in labor costs, etc. are all possible. Such events increase the cost of reconstruction.

Within the CPP is the option to apply a hedge against these unexpected increases known as Inflation Guard. This coverage option increases the amount of coverage on a daily, pro-rata basis throughout the policy term.

For example, assume a building valued at $100,000 has the 6% inflation guard option added to the policy. Six months into the policy term the insured has $103,000 available if needed (1/2 of 6%). The amount of coverage increases a small amount each day.

Applying the inflation guard option is one more step in hitting or getting as close to possible to a structure's reconstruction cost. The available inflation guard percentages begin at 2%. According to ISO rules, the percentage is in 2% increments and can be as high as the carrier will allow (thus the maximum percentage varies from carrier to carrier). Each 2% increment adds about 1% to the property premium.

Building to Reconstruction Cost

Developing and building to reconstruction cost requires the use of many different options and endorsements available within the commercial property program. Given the information provided in this report, following is a chart demonstrating how these parts build to reconstruction cost.

COVID and Reconstruction Cost

COVID has created conditions no one (well, maybe a few) ever anticipated. The cost of building materials has skyrocketed during the shutdowns and subsequent movements towards reopening. Supply chains have been disrupted, delaying delivery of materials; individuals and businesses have undertaken renovations and additions due to time (and boredom), causing increased demand. Contractors are booked solid, causing labor and timing issues.

Because of COVID and the resulting issues, insurance professionals must address the realities of reconstruction costs with their clients. Even if an inflation guard endorsement is attached, the percentage is likely too low in wake of the current situation.

​Mid-term limit adjustments may be necessary. At the very least, notify insureds via a letter or other communication of the current construction cost reality and document the notification in the client's file.  

Last updated: April 30, 2021​