Business owners commonly ask, “How much coverage should I have on my building?” But answering such a question can be like painting a moving train, depending upon how you use your building, what you want to do with it should it become damaged, how it is constructed, and a few other factors.
One little-understood variable in this equation is the property valuation method. Valuation method is the means in your insurance policy by which the building and/or contents will be valued at the time of a claim. This is agreed upon before a claim arises. Most often a single valuation method is applied to the entire policy. However, each building, and even the contents therein, can be valued using different methods if it better suits the needs of the client.
The three main valuation methods utilized for commercial property are replacement cost, actual cash value, and functional replacement cost. Others exist, but these are primary.
Replacement cost
Replacement cost is the most popular property insurance valuation method. It covers the cost to repair or replace a building with materials of the same or comparable quality; replacing old with new. For example, should a manufacturing facility be damaged by fire, destroying a production line, it will pay to repair or replace the production line with new machinery. Suppose the building was constructed of solid brick masonry and was damaged in this same fire, it will pay to repair or replace the structure with new materials, restoring its original condition.
Actual Cash Value
Actual cash value is another popular property insurance valuation option. This is like replacement cost, but a deduction is made for depreciation to the original property. Think of actual cash value as being replacement cost minus depreciation, with the amount of depreciation calculated based upon the expected life of the property.
Sometimes business owners insure a building utilizing replacement cost, but certain contents utilizing actual cash value. In our manufacturing facility fire example, if other suitable production machinery were to be abundant and readily obtainable, the owner may elect to insure those items at actual cash value instead of full replacement cost.
Although actual cash value allows an owner to insure property for less than replacement cost, it also pays less in a claim. Claims can be complicated with actual cash value, and we encourage you to read Property Insurance Valuation for claims examples. Consult your insurance agent before insuring property for actual cash value.
Functional Replacement Cost
Functional replacement cost is not as widely utilized as the previous two methods, but is valuable in certain circumstances. This method repairs or replaces the damaged property with materials that will perform the same function, even if it’s not the same kind of property. In our manufacturing plant example, functional replacement cost will pay to repair or replace the damaged structure with less expensive, modern construction methods. A metal building will cost less than rebuilding a solid brick structure, while still serving its intended purpose. Thus, at the time of claim, the old brick structure would be valued considering the cost of its modern functional replacement.
This same example can illustrate how this valuation method can be useful. Should the brick building cost $300,000 to replace using the same building methods (replacement cost), but only $150,000 to replace using functionally equivalent methods (functional replacement cost), the client could insure their building for $150,000, thus reducing insurance coverage and premiums while not putting themselves at financial risk.
Functional replacement cost should only be utilized at the advice of your insurance agent. Furthermore, its availability varies by insurance company.
To answer the original question, several variables must be considered when deciding on the best level of property coverage, including valuation method. Be sure to contact your Bankers Insurance agent with questions. Not a client of ours? Let us compete for your business! Each client is assigned a personal agent in our office, given their email address, and provided a phone number that rings right on their desk.
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