The replacement cost language in ISO Homeowners and Property forms also lists certain property that is to be disregarded in determining whether the 80 percent requirement has been met. This is not to say that the property is excluded from replacement cost recovery if loss or damage falls within policy coverage; its value simply need not betaken into account in measuring compliance with the mentioned requirement. The list consists of the cost of excavation; underground flues, pipes, wiring, and drains; and foundations, piers and other supports below the lowest basement floor, or, where there is no basement, below the surface of the ground inside the foundation walls.

See our article on Full Replacement Cost Insurance for a full discussion of replacement cost insurance.

How is actual cash value determined?

The term "actual cash value" is used in most property forms as well as inland marine forms and auto physical damage forms. Although the term is often not defined in the policy, it is commonly understood to mean "replacement cost minus depreciation."

The insuring clause of the 1943 New York standard fire policy, which forms the basis for many of today's property coverage forms, states that the insured is protected "to the extent of the actual cash value of the property at the time of the loss but not exceeding the amount which it would cost to repair or replace the property with material of like kind and quality within a reasonable time after such loss." While the standard fire policy per se is no longer a part of Insurance Services Office policies, all of the ISO property forms use wording similar to the standard fire policy in their loss payment clauses.

Over time, courts have developed three primary tests to measure the actual cash value of property. They are as follows:

• Fair market value, usually described as the price a willing buyer would pay to buy property from a willing seller in a free market.
• Replacement cost less depreciation,generally accepted to mean the cost to replace property at the time of the loss minus its physical depreciation.
• The broad evidence rule, a judicious application of either one or two to the unique circumstance of the claim, whichever is more favorable to the insured.

Which test will be used in a particular loss can depend on the jurisdiction under which the loss is to be adjusted. Different states subscribe to different rules, having developed variations of the three tests by case law and legislation. The definition most often used today incorporates what is known as the "broad evidence rule."

One thing insureds need to keep in mind is that everything depreciates over time and everything loses value, some things faster than others. Wear and tear are also a factor. A 5-year-old sofa that the cat routinely clawed will be worth less than a 5-year-old sofa where the insured had no pets.

For a full discussion of actual cash value and how it has been defined by the courts, refer to our discussion Actual Cash Value – A Changing Concept.

Replacement cost, actual cash value and coinsurance—all a factor in claim settlements

The following claim scenarios show how determining whether an insured should settle at replacement cost or actual cash value is not a hard and fast rule, and it may depend upon factors such as whether the insured is planning to replace old with new, whether or not furnishings are obsolete or unavailable, whether a change of operation or location might be considered after a loss, and the effect of coinsurance application on the final settlement.

Replacement costs exceed replacement cost cap

Question:

Our insured's structure was completely destroyed by fire, and the replacement cost was determined through appraisal to be $1 million. The insured rebuilt and spent $1.5 million. Assuming the replacement cost cap in the CP 0010 is the lowest of the three possible tiers for determining insurer liability, does the insurer have the right to contest the extent to which the insured builds a newer and better structure?
The insurer claims that if the insured did not use top-of-the-line materials or make improvements not covered under the policy, such as code upgrades, the insured would not have exceeded the replacement cost cap. The insurer also argues that the structure—because it is several floors shorter than its predecessor—should have involved an actual expenditure less than the replacement cost. As a result, the insurer seeks to challenge each line item of the rebuilding process to determine whether it was permitted or covered. They are attempting to show that the insured is entitled to something less than replacement cost.

We believe that as long as the building is a functional equivalent, the only time an insured is not entitled to the replacement cost is when it doesn't actually spend that much money. But can the insurer demand appraisal or court determinations regarding how the insured spent its rebuilding money?

Answer:

Under the CP 00 10 activation of replacement cost coverage provision, the form pays the least of the following: (1) the limit of insurance applicable to the property; (2) what it costs to replace the damaged property with comparable material and quality at the same location for the same purpose (though actual rebuilding need not occur at the same premises); or (3) what the insured actually spends "that is necessary" to repair or replace the damaged property (leaving the insurer some discretion over the amount of payment for costs actually incurred).

In your situation, a calculation should have been made to replace the building similar to its original design with materials of "like kind and quality." Thus, if it was a three-story brick building, that would be the basis. Then that amount should be the basis to build a structure that is "for the same purpose" (i.e., functionally equivalent).

If the owner replaces the brick with granite, only the cost of brick would be payable with the owner picking up the difference. It should not matter whether the building is the same shape or number of stories as much as that it be designed for the same purpose and use materials of like kind and quality.
Additional repair/reconstruction costs are bounded by the requirement that expenditures be "necessary" to repair or replace the damaged property. Of course, additional costs to comply with ordinance or law lie outside this parameter.

The CP 00 10 form does provide that either the insured or insurer may demand an appraisal of the value of the property or amount of the loss.

Replacement cost and ordinance or law coverage

Question:

I am an appraiser for the insured on a commercial building fire loss. The insured has code upgrade/ordinance or law coverage of $250,000.

The appraiser for the carrier has broken out the claim into three parts, and I agree with this division: replacement cost, actual cash value, and code upgrades. However, the other appraiser has divided every trade between what is code and what the insured already had. For example, if the electric did not meet current code and had to be replaced, the appraiser is depreciating the electric and pushing the code difference to the ordinance or law coverage and into the code column.

I believe this is incorrect and makes a huge difference on coverage amounts for codes versus what the insurer will pay and how much is being withheld on the claim settlement.

I have always understood that the code coverage was used for items needed to add to the rebuild that the insured did not have before the loss, such as updates to bring the building into ADA compliance.
If the appraiser is correct, how can the replacement cost definition or actual cash value have any relevancy? If I have to replace the shingles on a 25-year-old roof due to a covered claim, does the carrier normally deduct depreciation and the upgrade necessary to meet the new code standards of those shingles?

Answer:

We are basing the answer on the ISO CP 04 05, Ordinance or Law Coverage. Under this coverage, with respect to the building that has sustained covered direct physical damage, the form will pay the increased cost to repair or reconstruct damaged portions of that building and/or reconstruct or remodel undamaged portions of that building, whether demolition is required, when the increased cost is a consequence of enforcement of the minimum requirements of the ordinance or law.

So, yes, the coverage is for items needed to bring the building up to code that the insured did not have before, but the form pays only the difference between what the insured already had and what is needed. If the electric that was not up to code is to be replaced up to code, then only the amount necessary to bring it up to code is addressed by this coverage; the rest is under the building and personal property coverage.

What is of importance here is that according to ISO's rules, when the increased cost of construction coverage is selected on CP 04 05, the replacement cost coverage option of the underlying policy must be activated. In this claim situation, ACV would not come into play for this coverage because the coverage applies only to RCV.

Replacement of home—how is amount determined?

Question:

We are in the process of adjusting a large fire loss under a homeowner's policy (HO 3). The estimated replacement cost is $289,450; the actual cash value, $237,400.

Early in the adjustment process, we issued a check to the insured in the amount of $237,400. He replaced the damaged property for a total of $256,450. We contend that we owe him an additional $19,050—the additional amount he actually spent on replacement. The insured (and some people in our office) believe that we owe him $52,050—the difference between the actual cash value and the estimated replacement cost.

We'd appreciate an explanation of how this process should work.

Answer:

Even though the estimated replacement cost of the loss is $289,450, the insurer does not owe any more than $256,450—the amount actually spent by the insured. The loss settlement condition in both the HO-3 (84 edition) and the HO-3 (91 edition) limit the insurer's payment to the smallest of the following:

1. The limit of liability.
2. The replacement cost of the building (or the damaged portion thereof).
3. The amount actually spent to repair or replace the damage.

Since the insured spent only $256,450, he is entitled to an additional payment of $19,050 over the ACV payment of $237,400.

Closing costs as part of replacement cost

Question:

Our insured has a standard HO-3 policy.They suffered a total loss of their home due to a fire. They have elected to not rebuild on the insured premises but instead have purchased another home in another location.

To date they have been paid the ACV of the insured dwelling. What is the obligation of the insurer to pay up to the RCV of the original insured structure, if any, and would real estate closing costs on the replacement dwelling be considered part of the covered loss?

Answer:

Once the insured has replaced the dwelling, the carrier should pay the RCV. The standard loss settlement provisions apply, that the insurer pays the lesser of the limit of liability, the replacement cost of the damaged areas, or the necessary amount spent to repair or replace the building. Closing costs are part of the replacement of the building and should be covered.

Is refurbished equipment an accepted replacement of damaged property under replacement cost coverage?

Question:

The insured is a hospital covered under the attached Electronic Data Processing Equipment Policy form PD20 (4/07). The hospital sustained water damage to a piece of equipment - CATH Lab #4. The estimated RCV new is $1,000,000.00. The estimated RCV new (refurbished) of like kind and quality is $300,000.00. The insured has the optional coverage for replacement cost on its policy.

The insurer has located a new, refurbished CATH Lab #4 in good condition that is the same age and model as the one that was damaged. Is this an adequate replacement, or is the insured entitled to a new CATH Lab #4? Please see page 3 of the policy, Rules for Loss Adjustment.

Our thoughts are that since the policy has replacement cost coverage for the DP equipment, the insured would generally be entitled to receive the cost to replace the lost or damaged property with new property of comparable material and quality, without deduction for depreciation—not a used equivalent. Do you agree?

Answer:

The policy reads as follows for the replacement cost coverage:

Replacement Cost. We will pay the cost of repairing or replacing the damaged property without deduction for depreciation.

However, we will not pay more than the smallest of the following:

1. The limit of coverage that applies to the computer.
2. The amount you actually spend in repairing the damage, or the amount it would cost to replace the damaged property at the time of the loss with new property of equal performance, capacity or function.
3. If replacement with new property of equal performance, capacity or function is not possible, its replacement by property having the nearest higher performance, capacity or function to the property lost, destroyed or damaged.

Even though the term 'new' is added to the description of the refurbished equipment, it is not a new product but rather a used product that has been restored to its former function; thus,the lower price point. Even though the refurbished equipment has the same performance, capacity, or function, it is not the same as a new product as described in the replacement cost provision. While it is common for electronic equipment to be available as refurbished, if the carrier wanted the option to replace with a refurbished product, this should have been clearly stated in the policy language, which it was not. Therefore, the insured is entitled to a new CATH lab.

Replacement coverage for awnings

Question:

Our question concerns replacement cost coverage for awnings. In the ISO commercial property form CP 00 10 04 02 it says under the valuation condition clause b. that "If the Limit of Insurance for Building satisfies the Additional Condition, Coinsurance, and the cost to repair or replace the damaged building property is $2,500 or less, we will pay the cost of building repairs or replacement." It goes on to say that the provision does not apply to: (1) awnings or floor coverings; (2) appliances for refrigerating, ventilating, cooking, dishwashing, or laundering; or (3) outdoor equipment or furniture.

Does this mean that the replacement cost option does not apply to awnings?

Answer:

The replacement cost option does apply to awnings.

The valuation clause establishes that the policy will value covered property at actual cash value, with a number of exceptions, one of which is exception"b" you referred to. It says that if a loss is less than $2,500, it will be covered at replacement cost automatically; but the exception to the actual cash value does not apply to awnings, among other items. Thus, in an actual cash value policy, awning losses of under $2,500 are valued at actual cash value, as are awning losses of over $2,500.

When the replacement cost option is selected, the policy says that the words "replacement cost" are substituted for the words "actual cash value" in the valuation clause. That makes exception "b" to the valuation clause irrelevant. If all losses are valued at replacement cost, there is no need to select losses of $2,500 and under and state that they are valued at replacement cost. If exception "b" is irrelevant, it is meaningless to say that the replacement cost coverage it grants does not apply to awnings, which are already covered at replacement cost by selection of the replacement cost option.

AAIS Policy—Actual Cash Value or Replacement Cost on farm outbuilding?

Question:

Our farmowners client is covered on an American Association of Insurance Services (AAIS) policy. Our insured has suffered a wind loss that destroyed one of the structures on his farm. The insurer has offered an actual cash value settlement under coverage B (related private structures), and we believe it should be settled on a replacement cost basis.

The insurer has taken the position that this structure was a farm outbuilding (chicken house) converted to a garage and should have been insured as a normal outbuilding (ACV). When we applied for replacement cost coverage, we sent pictures showing the structure as a garage. If the insurer felt it should have been written as an outbuilding, they had the pictures and should have made such a request at the time the policy was issued.

The insurer has since paid the loss on an ACV basis. The adjuster says this building does not qualify as a garage and that the actual cash value figures are final. He will not even consider replacement cost figures.
The policy implies that the insured must rebuild to get replacement cost. Our insured is going to rebuild, but not just a private garage. He is going to rebuild a pole structure that will be used as an implement building and a place to house his automobiles. The adjuster is also implying that if the insured does not rebuild the same type building, replacement cost would not apply.

Answer:

If, as you say, the company underwriter knew that he or she was accepting—under Coverage B—a converted chicken house, then the company is obliged to adjust that loss according to the procedure laid out for coverage B in the conditions—replacement cost.

We realize that the definition of property covered might contain an "out" for the insurer. That provision says that coverage B does not apply to "buildings designed to be used for farming purposes, whether or not such buildings are currently used in connection with farming operations." However, that would apply only in the case of unscheduled outbuildings. Again, the insurer knew what it was getting and is obligated to honor the promises of the policy.

Your insured is under no requirement to rebuild the same building as was there previously. Similarly, if the insured's frame, one-story home had been blown away, he could choose to replace it with a brick tri-level.

However, what the insurer pays him for the converted chicken house is limited to the least of the following:

1. the coverage limit;
2. the cost to repair or replace the converted chicken house;
3. the amount the insured actually spends to replace the building.

Rebuilding as a different operation

Question:

I'm working with an attorney on a fire claim,and the policyholder has a commercial policy in place. The building was deemed a total loss and the insured has been paid the actual cash value (ACV). The insured had a bar/restaurant that burned and now he wants to rebuild a bed and breakfast instead. We have determined by using several contractors that the cost to rebuild a similar sized bar/restaurant with like, kind and quality would exceed the limit of insurance. Now the insured wants to rebuild a bed and breakfast instead again using a similar sized building with the same type of construction. My question is "can the insured collect full replacement cost provided he builds a like kind and quality building even though it would be used for a different type of business?" If FC&S can help me decipher this coverage issue, please get back to me.

Answer:

With respect to the replacement cost option of the ISO commercial property form CP 0010 1012, the insurer will not pay more for loss or damage on a replacement cost basis than the least of the below three options. In addition, the cost of repair or replacement will not include any increased cost attributable to enforcement of or compliance with any ordinance or law regulating the construction, use or repair of any property. The replacement cost options are:

1. The limit of insurance applicable to the lost or damaged property;
2. The cost to replace the lost or damaged property with other property of comparable material and quality; and used for the same purpose; or
3. The actual amount spent necessary to repair or replace the lost or damaged property.

Therefore, replacement cost valuation would not include the cost to replace the bar/restaurant with a building to be used for a different purpose, such as a bed and breakfast.

Replacement cost and purchase of new dwelling

In this scenario, the insured receives no benefit from the replacement cost coverage when replacing the damaged dwelling with another dwelling of lesser value. The cost of repairs for the damaged dwelling cannot be alternatively applied to a different replacement dwelling.

Question:

On a Replacement Cost Dwelling Package or Homeowners policy, an insured wants to take an ACV settlement on the dwelling and purchase another dwelling to make claim for the remaining available funds. The dwelling being purchased needs repairs and the cost to purchase it is less than the replacement cost of the original dwelling. May the insured make a claim for the cost of repairs to the new dwelling up to the available loss settlement amount once he has closed on the new house?

Answer:

The policy is a contract for the existing property, not a new property. The claim payment is for the property that was damaged, not to repair a new property that was never on the policy. If the insured wants to receive full replacement cost, he needs to purchase an intact dwelling for that amount. Otherwise, the insured has made the decision to take only ACV because he opted to buy a home in lesser condition.

Replacement cost less than actual cash value

In this scenario, because the insured opted to purchase a lower priced building at a different location, an actual cash value settlement would have been of greater financial value than the replacement cost settlement.

Question:

Our insured owned a building that was destroyed by fire. The building was insured on an ISO form CP 00 10 10 90. The actual cash value (ACV) of the building was $190,000, but the insured had it covered at a replacement cost value of $300,000. Rather than replacing the building at the same location, the insured got a good deal and bought another building at another location.

The new building was one third larger than the destroyed building, yet it cost less. It cost $230,000, and the insured put $20,000 into it to make it usable for a total of $250,000. Since the building is one-third larger than the old building, the insurer wants to pay only 75 percent of the cost of the new building, or $187,500. This figure is less than the ACV on the old building. The insurer claims that the extra square footage in the new building is a betterment and should not be paid for by them.

Is it right for the insurance company to pay less than actual cash value when the insured was able to do everyone a favor by negotiating a good deal at a cost that was under the replacement cost limit? Should the insured get full replacement cost, actual cash value, or the value of the new building pro-rated for the number of square feet in the destroyed building?

Answer:

This is one of the few examples of a replacement cost settlement on a commercial property loss paying less than an actual cash value settlement. Situations such as this are why the insured is given the chance to choose an actual cash value settlement even though the replacement cost option is in force.

Under paragraph e. of the replacement cost option, the insurer states that it will pay the least of three replacement costs: (1) the limit of the policy; (2) the cost to replace the property at the same location with comparable material and quality for the same use — whether the building is actually replaced or not; or (3) the actual amount spent to replace the property at any location.

In your insured's case, the third option applies and must be used. Since the replacement property was one-third larger than the original property, the cost of actually replacing the destroyed property's square footage is 75 percent of the cost of the new property (that is, 100 sq. ft. X 1.333 = 133 sq. ft.; but 100 sq. ft. = 75% of 133 sq. ft., because 133 X .75 = 100). Since the new property costs less per square foot to construct than the old property, the insured receives a lower settlement at replacement cost than if he or she had chosen the actual cash value valuation.

This is why the replacement cost option gives the insured the opportunity to choose an actual cash value settlement even though the replacement cost option had been activated. The framers of the policy realized that, in some cases, ACV would yield a larger settlement than replacement cost.

Coinsurance requirement and actual cash value

This scenario illustrates that the coinsurance provision applies regardless if the insured chooses an actual cash value settlement.

Question:

I was recently discussing the application of coinsurance with an independent adjuster friend of mine. We were discussing the fact that the insured would be better off claiming the loss at actual cash value (ACV) versus replacement cost. The policy coverage affords a replacement cost coverage option and an 80 percent coinsurance policy requirement. The insured in this case was way underinsured. I demonstrated to my friend that the policy limit would be achieved at ACV, using a theoretical Fair Market Value/ACV as the basis for the coinsurance calculation of the ACV amount required to be carried. My friend mentioned later that he reviewed the policy and there was nothing to be found in the policy that required a coinsurance calculation to comply with the requirement if the insured elected to take ACV only.

Does the coinsurance clause in a policy that affords a loss measure at replacement cost become inactive when the claim is made at ACV only or should the coinsurance clause still be applied using ACV values? Is the coinsurance clause waived at ACV?

Answer:

Unless wording in the policy states otherwise, generally, the coinsurance clause applies whether ACV or replacement cost valuation is chosen. The ISO CP 00 10 states that if a coinsurance percentage is shown in the Declarations, the clause applies.

Replacement cost and coinsurance issue

This is an actual court case example of how the coinsurance provision was applied to a replacement cost loss.

Wetmore v. Unigard Ins. Co., No. 53061-5-I, 2005 WL 407366 (Wash. App. Feb. 22, 2005)

A Washington appeals court ruled that a coinsurance provision should be applied to the replacement cost of damaged property inWetmore v. Unigard Ins. Co.

The Majestic Inn was insured under a commercial multiline policy issued by Unigard Insurance. The policy contained a 90 percent coinsurance provision. A fire damaged the inn, and the owners, the Wetmores, made a claim on an actual cash value basis for $949,000. The Wetmores later made a claim for additional replacement cost coverage for $776,000—the difference between the policy limits and the actual cash payment they had already received. Unigard disagreed with the amount of the additional claim.

The Wetmores argued that the coinsurance provision did not apply to the replacement cost claim, but that it should be determined based on the property's actual cash value. The coinsurance provision did not apply to the actual cash value claim because the policy limit exceeded the actual cash value. Unigard, however, argued that since the replacement cost bid for the inn was over $3 million and the insurance limit was $1,725,000, the 90 percent coinsurance requirement was not met.

The court concluded that replacement cost valuation applied to the claim, stating, "Neither the policy language nor logic supports the view that this replacement cost claim is to be determined on an actual cash value basis."

The Wetmores stated that the policy provisions were susceptible to two reasonable interpretations. They claimed that because the word "value" was not defined in the coinsurance provision and based on the confusing nature of the policy's structure, an ambiguity existed and that the "general rule" is to base coinsurance provisions "upon the actual cash value of insured property."

Quoting Couch on Insurance, the court said that "[i]nsurerscommonly offer insureds the option of insuring improvements for replacement costs, in recognition of the fact that the cost of repairing or replacing an older structure will be greater than its value."

The insureds next said that the policy's provision leads to violation of a Washington statute that prohibits "insurance in excess of the 'fair value' (defined as cost of replacement less depreciation)." The court countered that the statute authorizes replacement insurance in situations like the insured's, noting that replacement cost coverages are designed to insure against the risk of deterioration. The court said that "the over-insurance statute cannot be read to prohibit insuring a property close to or at its replacement cost value as required by the coinsurance provision in this case."

The court affirmed summary judgment in favor of Unigard.

For further reading:

Homeowners Loss Settlement Options

Actual Cash Value – A Changing Concept

Homeowners & Dwelling – Replacement Cost Insurance 
The Issue of Matching