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Understanding Replacement Cost

By: Clyde Patterson

Understanding Replacement Cost By Clyde Patterson | IICRC | July 2016 NewsletterOne of the most common misunderstandings in the realm of business insurance revolves around the concept of replacement cost as it pertains to an insured building. If the policy says “replacement cost,” many policyholders file their renewals away and believe that they do not have anything to worry about. Even a total loss, which would be devastating in and of itself, could be given a jump start knowing that one has replacement cost.

The most important factor to keep in mind in this discussion about replacement cost is its complete lack of relationship to market value. The two terms are many times considered synonyms, but nothing could be more mistaken than that.

Replacement cost considers the cost to rebuild or repair a building with like kind and quality materials, with a variance for labor cost in that area. For example, a building with the same dimensions and of the same construction type will have different replacement costs in Chicago versus Sioux City, Iowa. But in neither case would that cost be the same as its market value.

Annually, a key point of discussion with your insurance agent should be, “How did you determine the replacement cost of my building?” When something unforeseen happens, a policy may have “replacement cost” stamped all over it, but the policy will not pay more for a building loss than the limit of building coverage shown on your policy.

Another factor to consider is what is known as coinsurance. What does that mean? In commercial insurance, some building owners elect to not fully insure their buildings through the use of coinsurance. The least amount of coinsurance that may be used is 80 percent. So if a building is being insured for $1 million at 80 percent coinsurance, we are telling the underwriter that the full replacement cost is actually $1.25 million.  But with coinsurance, the insurance carrier allows us to partially offset some premium charge by not fully insuring the total value at risk.

But we must be careful with coinsurance. Using these percentages can make it easy to accidentally underinsure your building, and all standard property insurance will invoke a penalty for doing so. This means that not only would the whole claim not be paid because the limit is insufficient, but even what would be paid would be reduced by a percentage correlative to the difference between what the limit should have been and the limit documented on the policy.

By understanding the true meaning of replacement cost, and how it differs from market value, as well as the concept of coinsurance, you can better protect your valuable property assets.

Clyde Patterson is a licensed commercial insurance broker and the Vice President of Service Insurance Agency. His career in insurance began over 30 years ago. He earned his Bachelor of Science Degree from the University of Illinois at Champaign Urbana and is a Certified Insurance Counselor.

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