photo credit: flickr snapman

These days, most insurance against direct risks of property loss is arranged on a Replacement Cost (or “RC”) basis. The main alternative that is sometimes used is to insure property on an Actual Cash Value (or “ACV”) basis, which is defined as “Replacement Cost (at the time of loss) less Accumulated Physical Depreciation”. ACV insurance may sometimes be the only alternative available, but it should be avoided if at all possible, and understood fully if adopted.

Total losses can, and frequently do, happen. Even a relatively small fire can involve so much smoke damage, and water damage from fire suppression that the cost to make everything right equals the cost to replace the entire building and its contents. A big wind and rain storm can take off a roof, blow out windows, and soak everything so badly that a total loss occurs. One of the basic rules of risk management is “Don’t risk a lot for a little”. If your insurance program is properly designed, you can insure to 100% of your property’s RC at little or no increase in cost over skimping on Property insurance limits.The workings of Property Coinsurance helps control the cost of insuring at full RC. I like to describe Property Coinsurance as a “quantity discount” whereby the insurance company lowers the rate per $100 insured, the closer you get to insuring at 100% of values. As an approximation, the rate applicable to insuring at 100% of RC is 10% less than the rate to insure at 80% of RC. So, if your building could be replaced for $1 million and the 80% rate to insure it was $0.20 per $100, the premium for that $800,000 limit would be $1,600. If instead you elected to insure the full $1 million using 100% coinsurance, the rate would be about 10% lower, or $0.18 per $100 insured and the premium for that $1 million limit would be $1,800… 20% more insurance for just 12.5% more premium. We’ll go a little deeper into the subject of Property Coinsurance in a later blog.

It is uncommon (but not unheard of) for commercial Property insurance policies to provide “Guaranteed Replacement Cost”, which is a coverage enhancement that is sometimes provided by Homeowners insurance companies in their “preferred” or “executive” policies. If you elect 80% coinsurance and insure for $800,000 in the above example, and if there is a total loss, you’re only going to get the $800,000 – which obviously leaves you $200,000 short of the amount needed to rebuild. If your commercial insurance company does offer “Guaranteed Replacement Cost”, you’re paying a bit extra for the feature (and they will be careful to ascertain that you are actually insuring with at least a 100% limit anyway).

Remember, it is you, and not your insurance agent or company, that is responsible for determining the Replacement Cost of your property. RC has nothing to do with what the property originally cost, or its market value, or how it is carried on your books. Rather, RC means what it would cost to actually replace your property on the day the loss occurs. A professional appraisal from time to time would be ideal; or an opinion from a knowledgeable local contractor.