If you don't, you could be in for a shock should you have a claim.
That your property should be adequately insured, there is no doubt. What is much less certain, however, is what basis to use in determining your coverage, whether it’s market value or assessed value. Added to that are calculations like actual cash value, functional cash value, and replacement cost. Further complicating the issue is your need for coinsurance – or not.
Just reading these insurance terms can make your eyes glaze over. But don’t leave them solely to the understanding of your agent, however tempting. Since these six factors affect the amount you receive should you have a claim, make sure both you and your agent properly address these issues upfront, before you experience a loss.
MARKET VALUE VS. ASSESSED VALUE
Market value is defined as the price (of property) asked by a willing seller and agreed to by a willing buyer in an open market place. Many factors help determine this price, including location, specific property features and current market conditions. The only time the actual cost of construction enters into this number is when it is new construction.
Assessed value is defined as the dollar value of a piece of property assigned by a public tax assessor for the purposes of taxation. This value can be influenced by generic market conditions (properties in area) as well as economic and political forces.
ACTUAL CASH VALUE VS. REPLACEMENT COST VS. FUNCTIONAL VALUE
ACTUAL CASH VALUE
Actual cash value coverage reimburses you the replacement cost of property after deducting for depreciation. Your actual cash value cannot exceed the applicable limit of liability as shown in the declarations of your policy, nor should it exceed the amount it would cost to repair or replace that property with material of like kind and quality, within a reasonable amount of time after a loss.
This form of insurance coverage reimburses you the full replacement cost without deducting for depreciation, subject to the terms of the coinsurance clause. (More on coinsurance later.) This coverage applies to both building and contents as specified on the face of your policy.
FUNCTIONAL REPLACEMENT COST
Functional replacement cost covers the cost to replace damaged or destroyed property with property that serves the same function. Functional replacement cost is most commonly used when the damaged or destroyed property cannot be replaced by like property because doing so is either impossible or unnecessary to do.
Let me explain with an example. You’ve insured property that has extremely ornate and functionally obsolete architectural features. The building was destroyed by a tornado and declared a total loss. With functional replacement cost, the amount you receive from your insurance company would cover the cost of restoring your building to its functionality without necessarily reproducing its aesthetic features.
WHAT IS COINSURANCE AND WHY IT MATTERS
The most common property loss is a partial one, as total destruction of property is relatively rare. Given this fact, some property owners consider limiting the amount of insurance purchased. After all, why pay for full coverage when there is a better than 50 percent chance that the full amount will never be needed?
While you may be tempted to purchase a reduced amount of insurance, it would be foolhardy, because due to coinsurance, it will reduce the money you receive when you file a claim. Here’s how it works. The rates ordinarily used for insuring commercial buildings and personal property are calculated with the assumption that they will be used with an 80 percent coinsurance provision. Coinsurance is a property insurance provision that helps you avoid inequity and encourages you to carry an amount of insurance that accurately reflects the replacement value (or actual cash value) of the property. If the amount of insurance is not at least equal to a specified percentage of the value of your property, then the coinsurance imposes a penalty on the amount you receive in your claim.
It’s possible to choose a coinsurance amount of 90 or 100 percent as long as you are also purchasing a greater amount of insurance. A higher coinsurance percentage reduces the property rate.
The formula used to determine the amount payable after a loss when a coinsurance provision applies is:
Insurance carried X Loss = Amount recoverable
It’s not mandatory that you carry insurance up to the specific percentage, but if you don’t comply, a penalty will be imposed in the adjustment of the loss. To illustrate, here’s an example:
An insured commercial building is destroyed by fire in the amount of $50,000. The actual cash value of the building is $1 Million, but the amount of insurance on the building is $600,000. The policy contains an 80% coinsurance clause and a $1,000 policy deductible. To see how the claim payment was determined, use the above formula.
$600,000 X $49,000** = $36,750 paid toward loss.
** $50,000 less $1,000 Deductible
The coinsurance penalty in this example would be $12,250.
AGREED VALUE COVERAGE: WHEN COINSURANCE IS NOT REQUIRED
This coverage suspends the coinsurance clause if you and your insurance company agree on the property’s actual value and agree that the amount of coverage in your policy is both accurate and adequate for coinsurance purposes.
Regardless of what you and your insurance company agree is the valuation of the property or the percentage of coinsurance, it’s important that you have a process to ensure that the values for buildings and contents are appropriate, reasonable, and in sync with what your policy stipulates. When you file a claim, you’ll depend upon this process to create a timely proof of loss and to document items lost or damaged, helping you receive a proper loss settlement in a timely manner.
Monica Parrinello, CPCU