When disaster strikes, an organization’s insurance policy will be one of the best resources to fund the repairs to the resulting damage to real or personal property.
Your organization’s insurance policy likely includes the Replacement Cost New values of physical assets, but more often than not, the Replacement Cost New may not be the same as the claims value of the property that your organization needs to rebuild. As a result, your insurance return may not cover the full cost to replace the damaged property.
A closer look into why a disparity exists between the insurance claims value and the replacement cost value, and an understanding of the insurance valuation process, may help finance and risk management leaders prepare their business for the true expense involved in replacing damaged real and personal property.
Key Terms in Insurance Valuation
The insurable replacement value is a cost estimate that represents the general amount it would take to replace or reproduce insurable property if it were lost or damaged. In most, if not in all instances, the insurable replacement value includes the rebuilding of that exact structure and footprint. The insurable replacement value does not make assumptions about which building components might be modified, how the space might be redesigned to meld with modern tastes or building code upgrade costs.
Most insurance policies include a provision for claims payments to cover the Replacement Cost New (RCN) value of your property. This is the cost required to produce a property of like-kind and materials in accordance with current market prices for materials, labor, manufactured equipment, contractors’ overhead, and profit and fees. The RCN value does not include overtime or bonuses, and it does not include compliance with state or local ordinances or costs associated with the demolition of the damaged property or the removal of debris. An insurance valuation professional sets the RCN value by collecting / verifying data on-site and then completing an analysis of data and reporting of the findings.
How Do the Two Values Differ in Application?
Several factors go into the claims payment a property owner will receive from their insurance provider, but a few situations will almost always lead to the RCN value being lower than a claims value, resulting in out-of-pocket replacement-related expenses. These situations can include:
Complete Versus Partial Loss of Property
The partial loss claims value generally are much higher than a complete loss. In a partial loss, the amount involved may be based upon repair costs, which are higher than RCN values because they bring your damaged property to a condition similar to what it was before the damage, using contemporary materials that may be hard to find or replace.
Complications with the Demolition
In situations where there is unknown or sensitive matter in the debris, such as asbestos or lead, the cost to mitigate and remove the problematic material will not be covered by the RCN value.
Demand Surge -Fast-Track Construction Arrangements
RCN values operate under the assumption that the rebuild will follow standard construction practices and that contract documents, specifications, and drawings are complete before groundbreaking; numerous change orders that go above and beyond the average may not be covered. To the extent that the demand or fast-track construction arrangement price exceeds a standard construction contract price, the RCN value will not cover that differential.
Your organization may need to operate out of a temporary location while the damaged property is being repaired, such as if a school district experiences damage to its properties. This rental cost may be covered by claims value, but it would not be part of your RCN value-based claims payment.
Ways You Can Help Bridge the Gap
There are some ways to plan for the differential between claims and RCN values. Some insurance policies include a 5% contingency estimate or an ordinance and law insurance rider (covered in more detail below) to cover unknown factors, such as weather conditions, transportation costs, or congested or constricted building sites. This 5% will not likely cover the full amount of additional expenses that may arise when replacing damaged property, however.
You could also speak with your insurance appraiser as there are certain valuation methodology modifications that may bring the claims value and the RCN value closer together.
For example, if the municipality or state has instituted a sustainable construction protocol, the insurance appraiser can factor basic sustainable construction components into the modified RCN. An insurance appraiser can factor in some standard insurance items that are typically excluded in the industry from the final RCN value, such as underground piping, below grade foundations, footings, excavation, and grading, and incorporate these elements into the RCN value.
The insurance appraiser can assume that the new building will have a baseline of mandated law and ordinance provisions included. The original building may not have had a sprinkler system, fire alarm system, security system, cooling system, or an elevator, but the appraiser can add that value into the RCN value, when practical, to meet the present building code.
Additional Coverage Options
Many insurance policies accounts for existing property as it’s currently constructed. Neither the claims value nor the RCN value will cover the cost to upgrade the building to current building codes and ordinances after a loss. This could be a significant expense if you are working with an older property. A public building built in the 1970s, for example, would likely not be rebuilt in the same layout or with the same systems. The engineering and architectural changes needed to meet local codes and ordinances, and newly requested modern aesthetics and layouts would come at an additional cost to the property owners.
To prepare for this expense, businesses with older property may want to review with their insurance broker about the possibility of adding Ordinance and Law coverage to their property insurance policy. This coverage is typically included as an ordinance and law insurance rider.
For More Information
For a more in-depth discussion about the true cost to replace property, reach out to a member of tangible asset valuation team.
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