Explain Ordinance or Law Coverage To Avoid E&O Claims

I offer this short article as a handout agents can use to answer clients' questions about this complicated coverage. I hope it will lead some of your commercial policyholders to purchase the coverage they need and also help you to avoid an E&O claim.

Start with an Illustration

Consider this real claim scenario. The insurance agent had insured an older condominium complex in Florida with a top-rated insurer that automatically included $250,000 of ordinance or law coverage in its policy. Unfortunately, after the complex was hit by both Hurricanes Frances and Jeanne in 2004, the association found that it had $7 million less ordinance or law coverage than it needed.

Large uncovered claims like the one suffered by that Florida condominium complex are devastating to insureds. The rule to remember is, "The more zeroes in the uncovered claim, the more likely you are to feel E&O pain." That was the case in this claim. Even though the agent won the lawsuit, it would have been much better for all involved if adequate coverage had been purchased.

What You Don't Know about Ordinance or Law Coverage Can Hurt You!

Here's some good advice for building owners: even if your building is insured for replacement cost, if you do not have ordinance or law coverage, you probably do not have the protection you assume you have. A standard replacement cost policy will pay to replace "new for old," but only if the building codes (ordinances or laws) do not require a better "new" than you had before.

William Bracken, CEO of Bracken Engineering, gives the following two common examples.

• If your building does not have hurricane shutters or hurricane windows, and the new code requires them, your replacement cost policy will pay the cost of replacing your original windows but will not pay the increased cost for new hurricane windows or hurricane shutters.

• If your commercial building's roof needs to be replaced but the old roof did not meet the current energy code, the insurance company will pay the cost of replacing the old roof. It will not pay the increased cost for upgraded insulation or other expensive measures that may be needed to meet the current code.

What a Standard Replacement Cost Policy Won't Cover

When looking at the claim costs that can result from the enforcement of ordinances or laws, the standard commercial replacement cost property policy will not cover the following.

• The value of the undamaged portion of a building when the code requires it to be demolished

  For example, a $10 million building is 50 percent destroyed, and the local code requires that the undamaged remainder of the building be demolished. The standard insurance policy will not pay for the undamaged portion of the building that must be destroyed. To be insured for that, the building owner needs to have purchased ordinance or law coverage A. When it is purchased, it is usually automatically included for the full limit of insurance that applies to the building. As this example shows, even a brand new building needs ordinance or law coverage.

• The cost to demolish the undamaged portion of the covered building and to clear the site

  In the above example, the standard replacement cost policy will pay to clear away the debris from the original fire. It will not pay to demolish the undamaged portion of the building and clear the site. To be insured for that, the building owner needs to have purchased ordinance or law coverage B. The insured must specify what amount of coverage B it wants to purchase since the coverage is not written on a "whatever-it-takes-to-do-the-job" basis.

• The increased cost of construction due to the enforcement of building ordinances or laws for (a) the undamaged portion, (b) the damaged portion, and (c) items excluded from the standard policy

  Here are three scenarios.

  • No coverage for bringing the undamaged portion up to code

    Let's assume that a $10 million building is 40 percent destroyed. In this case, the local building code requires that the undamaged 60 percent of the building also be brought up to code at a cost of $600,000. The standard replacement cost policy would not pay the $600,000. (It would also not pay the $400,000 to bring the damaged portion of the building up to code, which is explained further in the next scenario.)

  • No coverage for bringing the damaged portion up to code

    Let's assume that the above $10 million building burns to the ground and that the portion of the replacement cost that is attributable to bringing the building up to code is $1 million. The standard replacement cost policy would pay only $9 million for the loss and would leave the $1 million uncovered.

  • No coverage for foundations, etc.

    If a building is destroyed, the local code will often prohibit the reuse of the building foundations, etc. The standard replacement cost policy excludes coverage on the cost of building foundations and pilings, underground pipes, flues and drains, excavation, grading, and filling. (It does this, presumably, because they are not damaged in most losses.) That means that the $10 million "replacement cost" of the building in the example does not include those items. Let's assume that the cost of these items is $500,000. The standard replacement cost would not cover that $500,000.

To have coverage for the above items, the building owner needs to have purchased ordinance or law coverage C for an amount sufficient to pay for the increased cost to bring the damaged (and any undamaged) portion of the building up to code, including the foundations, etc. In the above total loss scenario, that would mean they needed to purchase $1.5 million of additional insurance.

How Much Ordinance or Law Coverage To Buy?

Determining the amount of ordinance or law coverage that is needed is generally outside of the expertise of both building owners and insurance agents. Some building owners use a rule of thumb that demolition costs for buildings will run at least $5 per square foot for bricks and mortar type construction, and the average cost of bringing a building up to code will usually be 0.5 percent to 1 percent for every year the building is old.

Now that we have all of the information above, let's apply it to an example. The owner has a 30-year-old, 100,000 square foot masonry building with a replacement cost of $10 million. How much ordinance or law coverage should he carry?

• Coverage A (value of the undamaged portion of the building)—The full $10 million limit

• Coverage B (cost to demolish the undamaged portion of the building)—If the worst case scenario under the local code is that a building that is 50 percent damaged must be destroyed, then 50,000 square feet x $5 per square foot would require $250,000 of coverage B.

• Coverage C (cost to bring both the damaged and undamaged portion of the building and the foundation, etc., up to code)—15 percent would require $1.5 million coverage C, while 30 percent would require $3 million.

So, the insured would need the full policy limit for coverage A and would need from $1.75 million to $3.25 million for the combined coverages B and C.

"Rules of Thumb" May Miss the Mark

A customized appraisal by an appraiser who is knowledgeable about local building codes may be needed to make an accurate determination. The appraisal will cost a little money, but it is an excellent investment.

One other reality of the insurance marketplace is that sometimes insurance companies are not willing to sell all of the ordinance or law coverage that an insured needs. Then it will be up to the insurance agent to find the company that is willing to provide the most ordinance or law coverage at an affordable cost.

Conclusion

This is an overview of coverage and does not deal with the many different conditions and limitations that may apply. Whether you are an agent or policyholder, you will want to read your policies and consult with experts to understand how ordinance or law coverage applies to your own situation. Hopefully, this will lead to the purchase of the right amount of law or ordinance coverage … and will also help avoid an E&O claim.