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How do you properly insure older commercial structures that can be replaced with modern, less costly construction? We often hear from our clients, “If I were to lose my building in a fire, I would not rebuild it the same way. I only want to insure it for what it would cost to replace it.” This article will address how to properly value a building. Whether you occupy new, old, or refinished, you will find it applicable.
Valuing Your Building and/or Contents
An insurance policy generally allows you to value buildings and/or contents by:
- Replacement Cost: The cost to rebuild the building as it was, new for old.
- Actual Cash Value: Replacement cost minus depreciation. Can be similar to (not same as) market value.
When insuring an older building, many owners do not want to insure it at replacement cost. For example, if your office is in a bank built in the 1920’s with three-course brick walls, that would be quite expensive to replace today. You can do it, but let’s understand what it means before a claim occurs. For that answer, we need to visit a prison…
The Actuarial Dungeon
Somewhere in the dank basements of every insurance company, they chain retired statistics teachers to rusting desks and only feed them fluorescent light. Their crime was to get far too excited in math class. These poor souls are called actuaries, and they determine your insurance rates based on claim statistics. One of the assumptions of those statistics is that you will insure your building to its full replacement value. Therefore, if you don’t, the insurance company charges you with a penalty on your claim payment. We’ve written an earlier article regarding this underinsurance claim penalty for homeowners, but it is equally applicable to commercial structures. However, you have options.
Replacement Cost versus Actual Cash Value
One common way to reduce coverage on an older building, and not get an underinsured claim penalty, is to insure the building at Actual Cash Value. The best way to understand how Actual Cash Value works is through examples.
Using our 1920’s bank/office example, assume replacement cost for such a structure today would be around $300,000. However, to rebuild with a wood-frame structure, it would only cost $150,000. How would each look at claim time?
- Example 1: A fire destroys the building completely. If insured at $300,000 Replacement Cost, you get $300,000. If insured at $150,000 Actual Cash Value, you get $150,000. In this case of a total loss, the coverages react similarly. That is where the resemblances stop.
- Example 2: A hurricane blows off the roof and it will cost $40,000 to replace it. If insured at Replacement Cost, you get $40,000 minus any deductible. However, if insured at Actual Cash Value, the insurance company will take depreciation into account. Most likely, they would determine how old the roof was at the time of loss and reimburse you for any remaining useful life. That may mean you get anywhere from $0 if the roof was already in need of replacement, or $40,000 if it was brand new.
In summary, you can save money by reducing your coverage and insuring your older buildings at Actual Cash Value. However, in the event of a partial loss, depreciation will be taken into account and your claim payment will be lower than what the repairs will be.
To complicate matters, there are two other (rarely) used methods of valuation: Agreed Value and Functional Replacement Cost. But that will need to be addressed in a separate post…