I never actually did a survey, but I would be willing to bet when you ask an agent what valuation option you recommend to insureds for real property, they would say replacement cost. In practice, this happens at least 95% of the time. It is usually the correct valuation option to choose but not always and probably not the correct answer 95% of the time.
There are basically 3 valuation options for real commercial property. The first as (as mentioned above) is replacement cost. As the name implies, “replacement cost” insures for the value to replace or repair the property of like quality and materials without any deduction for depreciation subject to the limit purchased. Pretty simple! If you insure a 2,500 square foot wood frame restaurant and it burns to the ground. You get a new 2,500 square foot wood frame restaurant built back. The only thing the insured is out is the deductible they selected.
A second option is to insure the real commercial property for “actual cash value.” Under this method of valuation, actual cash value is defined as replacement cost less any depreciation. It would be nice as an underwriter, a risk manager, or an insurance agent, if they would define some of those terms within the policy but they do not.
Technically, they are accounting terms and not insurance terms. The definition of actual cash value is defined as “Actual cash value (ACV) is the amount equal to the replacement cost minus depreciation of a damaged or stolen property at the time of the loss” by Investopedia. The question remains is how is depreciation determined? This is more nebulous for real property than it is for personal property since real property maintains a value even after it may be 100% depreciated on an accounting basis.
Ultimately, it would be better it those definitions were defined within the policy language. It would make determining the insurable value of real property insured on an ACV basis.
That brings us to a third option, which is “functional replacement cost.” Functional replacement costs recognize in event of a total loss, owners of real property would elect to build back differently for greater effectiveness. For example, they may only be using half of their existing masonry building. If the building burned to the ground, they may not be interested in rebuilding a building the same size or they may opt for a steel pole barn type of structure as it may be more functional.
Functional replacement permits them to buy less insurance. In addition, the coverage form waives the coinsurance clause, relieving worries about application of a coinsurance penalty.
This brings us to a key point in talking about what type of valuation we should be recommending to our clients. To do so, we need to be engaging with our clients to picture what a post loss situation would look like. A simple question about how the envisions a post loss recover would look like.
Some clients given their druthers, would opt for a different type of building which may be more suitable for their operations. It is important to consider the idea they purchased their current structure because it satisfied their needs and not because it was the most optimal solution. Hence, replacement cost may be a less acceptable or less effective option than functional replacement cost.
In other cases, they would prefer to build at another location which may be more optimal to their current business model. Businesses evolve over time. Their markets evolve. While they may have started the business servicing client in Los Angeles, California, they may have expanded to servicing more clients in Phoenix, Arizona and would prefer to rebuild there.
Still, it is much more likely replacement cost is the appropriate choice. However, we should not be assuming it is always the best solution for our clients. In my opinion, insurance professionals tend to be geared to the one size fits all solution. Why do I think that? I think that because in all my years of underwriting commercial property, I can count on one hand the number of times I saw functional replacement cost requested and on the other hand the number of times actual cash value was requested. To me it is obvious we are not asking the question “how do you see yourself rebuilding after a total loss?”
The next question is “why is that?” Why are we not asking the right questions to help build a better risk management program for our clients? Perhaps that is the topic of a future blog.