Functional Replacement Cost Coverage and Its Practical Usefulness: Florida Valuation Issues, Part 8
(Note: This Guest Blog is by Michelle Claverol, an attorney with Merlin Law Group in the Coral Gables, Florida, office. This is the eighth in a series she is writing on valued policy laws).
Whether selling a commercial, homeowner, marine or other insurance rider, most insurance agents spend their days advocating the importance of insuring property with replacement cost coverage. Although this type of coverage is at times pricier than its “market value” counter part, replacement cost coverage will protect the property’s value against the dreaded depreciation due to the passage of time. However, sometimes the replacement cost option (new for old) is not the best choice for certain types of property.
Not all properties are alike. Buildings may have unique or obsolete construction materials and there may be large difference between replacement cost and market value at the time of a loss. Since generally, replacement cost coverage will be triggered after repairs or replacements have commenced, this scenario would put the policyholder at a financial disadvantage since the cost to replace damaged property with functionally equivalent property is more than its actual cash value and less than its replacement value. It should thus be considered “good business practice” for an agent to evaluate the uniqueness and value of the insured property before binding replacement coverage as the best valuation alternative.
Functional Replacement Coverage (FRC) is used when a functionally equivalent building can replace the original at a lower cost than would be required by an identical replacement. Functional replacement cost valuation provides a lower valuation than replacement cost, resulting in a reduction of the amount of insurance coverage required and thus lower premiums.
FCR coverage may be more favorable for certain items than actual cash value. Most FCR loss settlement provisions provide that losses will be settled following one of these two methods: replacement with a less costly, but functionally equivalent building; or, in the case of a partial loss, restoration of the damaged portion in the same architectural style, but with less costly material (ie replacing a mahogany banister with a pine banister).
The FC&S Bulletin explains the functional cost endorsement as follows:
“Functional Replacement Cost Loss Settlement (Forms HO 00 02,
HO 00 03, and HO 00 05 only)
HO 05 30 10 00This endorsement may be used when broader coverages are desired than those provided by the HO 00 08, but the insured or insurer does not wish to insure to full replacement cost. This might be the case with an older, ornate home that incorporates stone-, wood-, or plasterwork not readily available.
Replacement cost may so far outstrip market value that to insure based on replacement would do a disservice to the insured, since it is unlikely that the home could be replaced exactly as it stands. Therefore, use of this endorsement provides the insured with the broad range of coverages available in the ISO program, yet allows a more realistic amount of insurance to be selected.
The coverage A limit of liability is chosen based on "functional replacement cost," that is, the amount it would cost to repair or replace using materials that are functionally equivalent to obsolete, antique, or custom methods and materials. For example, plaster walls would be replaced with dry wall, pocket doors with plain doors. The loss settlement provisions substitute "functional replacement cost" anywhere "full replacement cost" appears.
Modified functional replacement cost loss settlement endorsement, HO 05 31, is virtually identical except that if the necessary amount actually spent to repair or replace is less than the actual cash value of the part of the damaged building then the loss is settled on an actual cash value basis.”
A recent opinion on functional replacement coverage was also published in FC&S Bulletin that should help a better understanding this valuation method and its practical usefulness.
Functional Building Evaluation Endorsement as Applied to Partial Loss
December 10, 2009
We have written an old church on a standard ISO form with a Functional Building Evaluation endorsement, CP 04 38 10 00. The building value is a fraction of what it would cost to be replaced but the limit is sufficient to put up a building of the same square footage that would be functional.
The insured suffered a partial wind damage loss. We adjusted the loss based on replacement cost less depreciation and offered that amount. The insured's agent is demanding that the partial loss be paid without the depreciation, at full replacement cost. Can you please advise if we are entitled to depreciate the loss because it is the smaller amount to settle the claim?Connecticut Subscriber
It is our opinion that you are not entitled to depreciate the loss. The CP 04 38 states that the insured will receive the cost to repair or replace the damaged portion of the building with less costly material, if available, in the architectural style that existed before the loss or damage occurred. This is not the same thing as receiving a depreciated amount, but is less than the full replacement cost because less costly materials are used.
Market value which is the value of a property within a specific market context(i.e. location, desirability,proximity to amenities etc.) should not be confused with A.C.V which is the actual cash value or replacement cost less applicable depreciation. You seem to use them interchangeably in this article.
I have only found rare instance where functional replacement cost would satisfy the insured.
I've seen this request most often for old Victorian homes converted to office of some type. The insured want's to pay premium based on a plain office building of equivalent size, but would not be willing or able to actually accept anything short of full replacement cost in the event of a loss.
Care must be taken to make sure alternate materials will be allowed (historical structures).
The cost to develop a clear plan of what would be built to replace the existing structure may be much higher than the premium differential between FRC and RC.
I suggest looking for premium savings through higher deductibles and shopping multiple markets rather than getting clever with valuation provisions.
Dear Shirley,
You are absolutely right. Market Value and Actual Cash Value are not one and the same. In this article I took a little bit of a poetic license and referred to ACV as the "market value" counterpart of of RCV to assist an audience that may not be as familiar and refined on the use these valuation concepts. Thank you for your comment and clarification.
Dear John,
You are also absolutely right. FRC is a very unique insurance product and it may only work best for historical or uniquely constructed properties. Like you said, many factors should be taken into consideration when selecting this type of coverage including the use of the building and taking into account that what works for some, may not work for all. Thank you for your time and comment.
Michelle Claverol