Commercial property insurance is commonly written on a replacement cost basis. What exactly, though, does replacement cost mean? And does replacement cost coverage violate the principle of indemnity?
Principle of Indemnity
The principle of indemnity is a fundamental concept underlying insurance coverage: Policyholders should be compensated for their loss, being restored to the same financial condition they were in prior to the loss. While insureds should be made whole, they should not profit from the claim or be in a better situation after the loss.
Does replacement cost coverage violate the principle of indemnity since the insured's new property is worth more than the older depreciated property was? One would not, for example, replace part of a damaged roof using building materials as old as the original materials; new materials would be used. Is the insured better off after the loss has been settled?
Although replacement cost coverage is commonly written today, this was not always the case. Early property policies such as the New York Standard Fire Insurance Policy valued property on an actual cash value (ACV) basis. The amount paid for a loss included a deduction for depreciation so that the insured would not profit from a loss; it would not receive new property when old property had been lost.
The problem with this approach, of course, is that an insured who suffered damage to a building, for example, often did not have the funds needed to replace the damaged property. While the insured may have been indemnified from a strict financial perspective, they were not in the same position that they were in prior to the loss—they didn't have a usable building. An Indiana court expressed this problem as follows:
It, nevertheless, cannot always be said that the insured has been "indemnified" if he is required to expend a substantial sum from his own pocket to restore his building, albeit to an improved condition, when it suited his purpose in its pre-loss condition.
It is sometimes said that replacement cost indemnifies the insured in a functional sense because, when the cost to replace the property is paid, the insured's property has the same functionality it had prior to the loss. When viewed this way, replacement cost does not violate the principle of indemnity.
What Is Paid with Replacement Cost Coverage?
The Building and Personal Property Coverage Form (CP 00 10 10 12) from Insurance Services Office, Inc. (ISO), allows the insured to select replacement cost as an optional coverage. When property is insured on a replacement cost basis, the policy pays the least of the following.
(1) The Limit of Insurance applicable to the lost or damaged property;
(2) The cost to replace the lost or damaged property with other property:
(a) Of comparable material and quality; and
(b) Used for the same purpose; or
(3) The amount actually spent that is necessary to repair or replace the lost or damaged property.…
The policy language describes the insurer's liability but leads to additional questions.
Must the Damaged Property Be Repaired or Replaced at the Same Location?
Earlier versions of the form include different language. The ISO Building and Personal Property Coverage Form (CP 00 10 06 95) limits recovery to the following.
(2) The cost to replace, on the same premises, the lost or damaged property with other property:
Some insurers interpreted this language to mean that the property had to be replaced on the same premises for an insured to be paid replacement cost. Most courts rejected this interpretation, finding the language to be simply a method of calculating damages and not a condition of coverage. What is a condition of replacement cost coverage is that the lost or damaged property must be repaired or replaced as soon as reasonably possible.
The phrase "on the same premises" was removed when the CP 00 10 form was next updated and published under CP 00 10 10 00. At that time, this sentence was added and is still in the current CP 00 10 10 12 form: "If a building is rebuilt at a new premises, the cost described in e.(2) above is limited to the cost which would have been incurred if the building had been rebuilt at the original premises."
What Can the Damaged Building Be Replaced With?
When a building is significantly damaged and more than a simple repair is needed, the insured may take advantage of the opportunity to remodel or make other changes to the building. They may rebuild the building, or they may choose to buy another building at a different location.
Must the new building, though, be an exact duplicate of the lost building? The answer is no. It is a common misconception that the replacement property can't be larger or more costly than the damaged property.
Another related misconception is that the insured must rebuild the building and cannot buy an already existing building somewhere else. Recall that policy language limits recovery to the cost to replace damaged property with property that is of comparable material and quality and that it be used for the same purpose. This clause addresses how the loss is valued; it does not mandate an exact replacement.
Many courts, for example, have stated that, for an insured to be paid replacement cost, the replacement property must have similar functionality. In a 2008 Texas case, Fitzhugh 25 Partners v. Kiln Synd. Kln,
261 S.W.3d 861 (Tex. App. 2008), a Dallas apartment complex owned by Fitzhugh 25 Partners, L.P., was damaged by fire; the damage was significant, and the property was demolished. Rather than rebuilding on the same site, Fitzhugh elected to purchase a 28.87 percent interest in a commercial office park in Houston.
The insurers initially paid Fitzhugh the ACV of the damage but refused to pay the $207,692.78 that was withheld as the difference between ACV and replacement cost. The insurer's position was that the interest in the commercial office park was not a replacement of the damaged apartment building. Fitzhugh argued that the commercial office park was functionally similar because it was a property with rent-paying tenants. The court ruled in favor of the insurer, stating as follows:
The amount of Fitzhugh's recovery under the policy was limited to the cost of rebuilding similar or comparable buildings on the same site or the amount it actually spent to replace the property, whichever was less.… For the replacement cost coverage to apply, however, Fitzhugh must have purchased or built a property that was functionally similar to the property that was destroyed.… If the new property is not functionally similar to the destroyed property, it is an unrelated expenditure and the destroyed property has not been "replaced."
Although Fitzhugh did not prevail because it did not purchase a functionally similar property, it is interesting to note the court's comments about what could have been purchased.
Under the policy, Fitzhugh was permitted to replace the apartments with different buildings at a different site as long as the new buildings were devoted to the same use. For example, it could have purchased or built a larger apartment complex at a different location.…
A Washington court described this concept well in Hess v. North Pacific Ins. Co.,
859 P.2d 586, 122 Wn.2d 180 (Wash. 1993), stating the following.
The effect of this limitation comes into play when the insured desires to rebuild either a different structure or on different premises. In those instances, the company's liability is not to exceed what it would have cost to replace an identical structure to the one lost on the same premises. Although liability is limited to rebuilding costs on the same site, the insured may then take that amount and build a structure on another site, or use the proceeds to buy an existing structure as the replacement, but paying any additional amount from his or her own funds.
The Ordinance or Law Connection
Zoning laws control how land can be used and include regulations involving permitted uses and building standards. "Nonconforming use" is a term used to describe buildings that are permitted in a particular area but no longer conform to current zoning regulations. These buildings are normally "grandfathered," meaning they are allowed to be used in spite of the nonconforming use. The right to continue nonconforming use, though, is often revoked when a building is damaged beyond a certain percentage of its value. In that case, the insured can only rebuild something that conforms to current codes, or it can rebuild at a different location. Either of these options may cost more than rebuilding the existing building at the current site.
Form CP 00 10 10 12 states clearly that "[t]he cost of repair or replacement does not include the increased cost attributable to enforcement of or compliance with any ordinance or law regulating the construction, use or repair of any property." Ordinance or law coverage is the solution to making additional funds available in cases where the insured is not permitted to rebuild the same type of building at the same location.
The increased cost of construction coverage (Coverage C) under ISO's Ordinance or Law Coverage (CP 04 05 09 17) endorsement, for example, pays the increased cost to repair or reconstruct damaged parts of the building and/or to reconstruct or remodel undamaged parts of the building when the increased costs are due to an ordinance or law. Typically, the coverage applies only when the rebuilt property is intended for similar occupancy as the current property. If that occupancy is not permitted by zoning or land use ordinances or laws, the insured can use Coverage C limits to build a different type of building or to rebuild at a different location.
The 180-Day Fallacy
There is a common fallacy that an insured must give an insurer notice that it will make a replacement cost claim within 180 days of the loss. Another related myth is that the insured must repair or replace the property within 180 days of the loss. If the insured does not act within 180 days, the claim will be paid at ACV.
If this were truly the way the 180-day rule worked, many insureds would never be able to collect replacement cost. Imagine, for example, the insured who doesn't discover hail damage to its roof until 7 months after a hailstorm. The 180 days have passed before the insured was even aware of the damage.
These mistaken notions likely come from language in CP 00 10 10 12, which states that "[y]ou may make a claim for loss or damage covered by this insurance on an actual cash value basis instead of on a replacement cost basis. In the event you elect to have loss or damage settled on an actual cash value basis, you may still make a claim for the additional coverage this Optional Coverage provides if you notify us of your intent to do so within 180 days after the loss or damage."
Note that policy language supports neither of these misconceptions; 180 days only comes into play when an insured has first made an ACV claim and later elects to make a replacement cost claim. The only requirement in this case is that the insured notify the insurer of the change in intent within 180 days of the loss.
In a Minnesota case, the insurer denied replacement cost coverage to an insured who did not notify the insurer within 180 days of the loss of its intent to make a replacement cost claim. The insurer made the following argument.
Every RCV claim necessarily presupposes an ACV claim, and thus the 180-day notice requirement was a condition precedent to receiving any RCV payment.
Source:
Construction Sys., Inc. v. General Cas. Co. of Wis.,
2010 WL 11575518 (D. Minn., Aug. 31, 2010).
The court ruled in favor of the insured on this point, stating that the first sentence of the policy condition in question undermined the insurer's argument. The court determined that the 180-day notice condition applied only when the insured first makes a claim for ACV and then later seeks replacement cost coverage.
Is Repair or Replacement of the Property Necessary for Replacement Cost Payment?
As was mentioned previously, CP 00 10 10 12 states that replacement cost will not be paid until the lost or damaged property is actually repaired or replaced. In addition, the policy requires that the repair or replacement must be made as soon as reasonably possible. This type of language is common and appears in most property policies.
When there is damage to property, an insurer will typically pay the ACV of the loss as a starting point. It is only when the insured produces evidence that the damaged property has been repaired or replaced that the amount withheld as the difference between replacement cost and ACV (i.e., depreciation) is paid.
Is repair or replacement of the property always necessary, though, for an insured to be paid replacement cost? Most courts have ruled that repair or replacement is needed for an insured to be paid replacement cost, as policy language is clear on this point. There have been a few courts, though, that have taken a different view.
In an Oklahoma case, the court viewed the policy's limitation of payment to ACV unless the property is replaced as unconscionable. The court ruled as follows:
Insurer required Plaintiffs to pay an extra premium to obtain replacement-value coverage. Insurer then, by the terms of its insurance policy, required Plaintiffs to replace their lost property before Insurer would become obligated to pay full replacement cost. Insurer, by means of this condition precedent, placed Plaintiffs, who lacked the financial wherewithal to replace the property, in a legal "Catch 22." Because Plaintiffs lacked the resources to provide for the loss (which was the purpose of their insurance contract), Insurer was able to compel them to accept the lower actual cash value of the property instead of the full replacement value coverage they expected and for which they paid.
Source:
Coblentz v. Oklahoma Farm Bureau Mut. Ins. Co.,
915 P.2d 938, 1995 OK CIV APP 126 (1995).
Conclusion
Replacement cost is not a simple as replacing old with new and, when viewed through the lens of functionality, does not violate the principle of indemnity. Questions involving how much is paid, what kind of property is a true replacement, and whether replacement is even required depend on the policy language, the details of the insured's loss, and how courts interpret coverage.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
Commercial property insurance is commonly written on a replacement cost basis. What exactly, though, does replacement cost mean? And does replacement cost coverage violate the principle of indemnity?
Principle of Indemnity
The principle of indemnity is a fundamental concept underlying insurance coverage: Policyholders should be compensated for their loss, being restored to the same financial condition they were in prior to the loss. While insureds should be made whole, they should not profit from the claim or be in a better situation after the loss.
Does replacement cost coverage violate the principle of indemnity since the insured's new property is worth more than the older depreciated property was? One would not, for example, replace part of a damaged roof using building materials as old as the original materials; new materials would be used. Is the insured better off after the loss has been settled?
Although replacement cost coverage is commonly written today, this was not always the case. Early property policies such as the New York Standard Fire Insurance Policy valued property on an actual cash value (ACV) basis. The amount paid for a loss included a deduction for depreciation so that the insured would not profit from a loss; it would not receive new property when old property had been lost.
The problem with this approach, of course, is that an insured who suffered damage to a building, for example, often did not have the funds needed to replace the damaged property. While the insured may have been indemnified from a strict financial perspective, they were not in the same position that they were in prior to the loss—they didn't have a usable building. An Indiana court expressed this problem as follows:
It is sometimes said that replacement cost indemnifies the insured in a functional sense because, when the cost to replace the property is paid, the insured's property has the same functionality it had prior to the loss. When viewed this way, replacement cost does not violate the principle of indemnity.
What Is Paid with Replacement Cost Coverage?
The Building and Personal Property Coverage Form (CP 00 10 10 12) from Insurance Services Office, Inc. (ISO), allows the insured to select replacement cost as an optional coverage. When property is insured on a replacement cost basis, the policy pays the least of the following.
The policy language describes the insurer's liability but leads to additional questions.
Must the Damaged Property Be Repaired or Replaced at the Same Location?
Earlier versions of the form include different language. The ISO Building and Personal Property Coverage Form (CP 00 10 06 95) limits recovery to the following.
Some insurers interpreted this language to mean that the property had to be replaced on the same premises for an insured to be paid replacement cost. Most courts rejected this interpretation, finding the language to be simply a method of calculating damages and not a condition of coverage. What is a condition of replacement cost coverage is that the lost or damaged property must be repaired or replaced as soon as reasonably possible.
The phrase "on the same premises" was removed when the CP 00 10 form was next updated and published under CP 00 10 10 00. At that time, this sentence was added and is still in the current CP 00 10 10 12 form: "If a building is rebuilt at a new premises, the cost described in e.(2) above is limited to the cost which would have been incurred if the building had been rebuilt at the original premises."
What Can the Damaged Building Be Replaced With?
When a building is significantly damaged and more than a simple repair is needed, the insured may take advantage of the opportunity to remodel or make other changes to the building. They may rebuild the building, or they may choose to buy another building at a different location.
Must the new building, though, be an exact duplicate of the lost building? The answer is no. It is a common misconception that the replacement property can't be larger or more costly than the damaged property.
Another related misconception is that the insured must rebuild the building and cannot buy an already existing building somewhere else. Recall that policy language limits recovery to the cost to replace damaged property with property that is of comparable material and quality and that it be used for the same purpose. This clause addresses how the loss is valued; it does not mandate an exact replacement.
Many courts, for example, have stated that, for an insured to be paid replacement cost, the replacement property must have similar functionality. In a 2008 Texas case, Fitzhugh 25 Partners v. Kiln Synd. Kln, 261 S.W.3d 861 (Tex. App. 2008), a Dallas apartment complex owned by Fitzhugh 25 Partners, L.P., was damaged by fire; the damage was significant, and the property was demolished. Rather than rebuilding on the same site, Fitzhugh elected to purchase a 28.87 percent interest in a commercial office park in Houston.
The insurers initially paid Fitzhugh the ACV of the damage but refused to pay the $207,692.78 that was withheld as the difference between ACV and replacement cost. The insurer's position was that the interest in the commercial office park was not a replacement of the damaged apartment building. Fitzhugh argued that the commercial office park was functionally similar because it was a property with rent-paying tenants. The court ruled in favor of the insurer, stating as follows:
Although Fitzhugh did not prevail because it did not purchase a functionally similar property, it is interesting to note the court's comments about what could have been purchased.
A Washington court described this concept well in Hess v. North Pacific Ins. Co., 859 P.2d 586, 122 Wn.2d 180 (Wash. 1993), stating the following.
The Ordinance or Law Connection
Zoning laws control how land can be used and include regulations involving permitted uses and building standards. "Nonconforming use" is a term used to describe buildings that are permitted in a particular area but no longer conform to current zoning regulations. These buildings are normally "grandfathered," meaning they are allowed to be used in spite of the nonconforming use. The right to continue nonconforming use, though, is often revoked when a building is damaged beyond a certain percentage of its value. In that case, the insured can only rebuild something that conforms to current codes, or it can rebuild at a different location. Either of these options may cost more than rebuilding the existing building at the current site.
Form CP 00 10 10 12 states clearly that "[t]he cost of repair or replacement does not include the increased cost attributable to enforcement of or compliance with any ordinance or law regulating the construction, use or repair of any property." Ordinance or law coverage is the solution to making additional funds available in cases where the insured is not permitted to rebuild the same type of building at the same location.
The increased cost of construction coverage (Coverage C) under ISO's Ordinance or Law Coverage (CP 04 05 09 17) endorsement, for example, pays the increased cost to repair or reconstruct damaged parts of the building and/or to reconstruct or remodel undamaged parts of the building when the increased costs are due to an ordinance or law. Typically, the coverage applies only when the rebuilt property is intended for similar occupancy as the current property. If that occupancy is not permitted by zoning or land use ordinances or laws, the insured can use Coverage C limits to build a different type of building or to rebuild at a different location.
The 180-Day Fallacy
There is a common fallacy that an insured must give an insurer notice that it will make a replacement cost claim within 180 days of the loss. Another related myth is that the insured must repair or replace the property within 180 days of the loss. If the insured does not act within 180 days, the claim will be paid at ACV.
If this were truly the way the 180-day rule worked, many insureds would never be able to collect replacement cost. Imagine, for example, the insured who doesn't discover hail damage to its roof until 7 months after a hailstorm. The 180 days have passed before the insured was even aware of the damage.
These mistaken notions likely come from language in CP 00 10 10 12, which states that "[y]ou may make a claim for loss or damage covered by this insurance on an actual cash value basis instead of on a replacement cost basis. In the event you elect to have loss or damage settled on an actual cash value basis, you may still make a claim for the additional coverage this Optional Coverage provides if you notify us of your intent to do so within 180 days after the loss or damage."
Note that policy language supports neither of these misconceptions; 180 days only comes into play when an insured has first made an ACV claim and later elects to make a replacement cost claim. The only requirement in this case is that the insured notify the insurer of the change in intent within 180 days of the loss.
In a Minnesota case, the insurer denied replacement cost coverage to an insured who did not notify the insurer within 180 days of the loss of its intent to make a replacement cost claim. The insurer made the following argument.
The court ruled in favor of the insured on this point, stating that the first sentence of the policy condition in question undermined the insurer's argument. The court determined that the 180-day notice condition applied only when the insured first makes a claim for ACV and then later seeks replacement cost coverage.
Is Repair or Replacement of the Property Necessary for Replacement Cost Payment?
As was mentioned previously, CP 00 10 10 12 states that replacement cost will not be paid until the lost or damaged property is actually repaired or replaced. In addition, the policy requires that the repair or replacement must be made as soon as reasonably possible. This type of language is common and appears in most property policies.
When there is damage to property, an insurer will typically pay the ACV of the loss as a starting point. It is only when the insured produces evidence that the damaged property has been repaired or replaced that the amount withheld as the difference between replacement cost and ACV (i.e., depreciation) is paid.
Is repair or replacement of the property always necessary, though, for an insured to be paid replacement cost? Most courts have ruled that repair or replacement is needed for an insured to be paid replacement cost, as policy language is clear on this point. There have been a few courts, though, that have taken a different view.
In an Oklahoma case, the court viewed the policy's limitation of payment to ACV unless the property is replaced as unconscionable. The court ruled as follows:
Conclusion
Replacement cost is not a simple as replacing old with new and, when viewed through the lens of functionality, does not violate the principle of indemnity. Questions involving how much is paid, what kind of property is a true replacement, and whether replacement is even required depend on the policy language, the details of the insured's loss, and how courts interpret coverage.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.