Question 1

What is Replacement Cost?

Accepted Answer

The easiest way to think about Replacement Cost is that the insurance company is giving you “new for old”. To justify the cost of fulfilling their contractual obligations to their policyholders and replace an old building with a new one, the insurance company needs to rate the cost of the insurance for the building based on the cost to replace it, not based on its actual cash value (which accounts for depreciation of the property).

Question 2

How Does a Co-Insurance Penalty Occur?

Accepted Answer

In times of soft real estate markets, it is very common for business owners to be able to acquire real property assets for far less than the cost to build. Ultimately, this creates confusion when the property owner seeks to obtain insurance coverage because the financial investment that they have put into the property is often lower than the limit of insurance on their policy.

In order to save money on their insurance policy, many insureds look to reduce the value of buildings that are listed on their declarations page. But, if Replacement Cost is on the policy, buildings need to be insured to 80% of the cost of replacement. If this requirement is not met, a co-insurance penalty will be assessed if a loss occurs.

Question 3

How is a Co-Insurance Penalty Assessed?

Accepted Answer

The factor used to complete the penalty calculation and determine how much of the loss the insurance company will pay is as follows: the amount the building was insured for, divided by the amount the building should have been insured for, multiplied by the amount of the loss, minus the policy deductible. So, for example, assume a building should be insured for $100,000, but the insured chooses to insure it for $70,000 with a $500 deductible. $70,000 is 70% of $100,000, so the 80% co-insurance requirement has not been met. Say our hypothetical building suffers a $5,000 roof damage claim.

Co-Insurance Penalty and Policy Deductible

Since the building was under-insured, the insurance company will use the calculation (70,000/100,000) X $5000 - $500. In this scenario, the insurance company will pay the insured $3,000 for the roof damage and the insured will be responsible for the additional $2,000 which is the amount of the co-insurance penalty and the policy deductible.

Straight Depreciated Value

The insurance company may also pay the loss based on the straight depreciated value. So, in this example, a $5000 roof claim on a 30-year-old shingle roof could be deemed 50% depreciated and your payment would be $2000 after the deductible is applied.

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