Valuation of Loss, Loss Settlement Methods, and Insurance to Value
Property insurance valuation has become a more prominent conversation these days since when property values began to take a dive at the beginning of 2008. A vigorous debate has opened up between property owners and insurance companies on how to properly insured homes and buildings. It might appear at first that there is a discrepancy between the valuation insurance companies use to provide insurance coverage for your dwelling and the valuation your local tax department has affixed to your property. That is not the case. While confusing, insurance concerns itself with two methods of valuation and ignores the market value that local tax offices may be reporting on your tax bill. The two different valuation methods we use shouldn’t be confusing and you need to set market valuations determined by your property tax officials off by itself. We are interested in it but don’t really use it in insurance.
Property insurance valuations are not difficult to understand. Your property taxes are based upon the approximate market value of your home as judged by the property tax agency in your area. Your taxes are based upon that calculation or a portion of that calculation (in areas where an “equalized” valuation method is in use). Insurance IS NOT issued upon the basis of “market value” because market value is inherently variable and does not reflect the promises we make to you in an insurance policy to help you rebuild or reconstruct your property. Insurance companies use two other method of valuation:
- Replacement Cost, and
- Actual Cash Value. Let’s explain.
Insurance companies cannot rely upon the fluctuations in market value to assure that we can repair or replace the dwelling structure. That is why we rely only upon the replacement cost calculations to set the structure coverage amount on home or rental dwellings, and even on commercial buildings. Unlike finding a used automobile value, which is rather easy, we don’t have an effective marketplace to buy used carpet, used lumber, plywood, drywall, wiring, etc, to replace your home. You wouldn’t want used carpet either anyway! That is why the only fair method for your insurance company and you to set the amount of coverage is based upon the replacement cost of the materials used to fabricate and construct your home. When you choose to have your home repaired, or when reconstruction is required due to the scale of the loss, proper insurance coverage means you will have enough insurance to buy new lumber, plywood, carpet, cabinets, wiring, and the other materials that go into reconstructing your building or home
If you don’t rebuild, if you don’t repair your home, then all insurance will owe you is the “actual cash value” of your loss. Actual Cash Value (ACV) is the depreciated value of the home or damage based upon its diminished useful life. ACV then is the value of your home on a depreciated basis and we always begin calculating the ACV from the Replacement cost of the structure based upon costs today. The reason we may not pay you the limit on your policy when you don’t choose to repair or rebuild a building is because doing so would give an owner the incentive to damage their own property. One of the important principles that support insurance is the concept of indemnity. If insurance is going to be an effective method of transferring the risk of loss, the “principle of indemnity” must be honored or losses will not only be predictable, they will be likely! The “Principle of Indemnity” essentially means that we return you to the point of beginning, the point just before the loss happening, with neither a loss or a gain. To pay you policy limits without the requirement that you rebuild would be a reward that violates the principles of indemnity and subject insurance to fraud and abuse. In insurance, there can only be a return to the point just before a loss without the chance of rewarding you for having had a loss.
As for your personal property, coverage “C” on your homeowner policy declaration page, replacement cost is an added coverage and needs to be specifically purchased to provide protection to your personal property. Replacement cost coverage on your personal property means that after a loss you will have been protected from the depreciation of a lost piece of personal property as long as you replace the item. As with the dwelling terms, if you don’t replace an item, you will receive only the depreciated value for an item or items after a loss.
There is a third method of valuation used to set the insurance amount. That is found only on an HO-8 home policy type. The HO-8 basis of valuation used to set the insurance amount is the “market value” of a home as if the loss occurred on the day before a loss. Most owner occupied properties will probably find other homeowner forms a better match for insuring their property. However, in some instances the HO-8 policy form makes sense. One example is when the property is very old and it would never be reconstructed using the same methods of construction, materials and techniques used when it was originally built. For example, we would use plywood and OSB sheet goods to deck a roof or floor. It was more likely 100 years ago that thick dimensional planks were used that just can’t be affordably acquired today. Another place a change makes sense in the wall surfacing material. Drywall material is ubiquitous and makes for more sense to use than plaster and horse hair and lathe common 100 years ago. The HO-8 policy is not widely available but is still in use by some companies.
There is one other area of concern as it pertains to the Property Insurance Valuation. In evaluating a loss, it is expected that you insured the property within a reasonable proximity of the ACV or replacement cost. Referred to as “insurance to value” (ITV), most carriers expect that full insurance is maintained on the property. Proper insurance amounts are not an exact science. It is best to have more insurance than needed, within reason, than too little insurance. The tools in use by companies today are reasonably good at helping establish the value to set insurance amounts. The values they determine are often the minimum required insurance amounts to be properly protected by the policy. Ohio is one of the states with a “valued policy law” on the books. In its strictest form a “valued policy law” requires the insurance company to pay the limit of insurance on a dwelling considered to be a total loss. In 1980 Ohio amended the law and added a provision exempting policies offering “replacement cost” building insurance from the requirement to pay the limit of insurance whether or not a person rebuilds their home. That is one reason I suspect that the HO-8 market value policy is not used more commonly than it is. The original intent of the “valued policy laws” were to protect the insured from after-the-fact bickering over buildings being over-insured and companies wanting to pay less than the amount of coverage purchased. Using replacement cost in the policy protects the insured from losing their homes and also protects carriers from rewarding customers for having a loss and walking away from their dwelling for the stack of cash.
Where it is feasible from a cost standpoint, and when an owner occupies a home, I suggest buying coverage on a replacement cost basis. The primary reason is that no depreciation is subtracted from a loss settlement for a partial loss. If the same loss were to occur on an unendorsed ACV policy, the final settlement is adjusted for the betterment by subtracting the depreciation. Some companies offer a “repair cost” endorsement but by the time it is added you’ll pay about what the replacement cost policy would have cost.
Property Insurance Valuation Methods are confusing and it does take some conversation sometimes to help make my clients understand the differences. If you want or need a conversation about property valuation for your home, dwelling, or commercial property, call me at (513) 779-7920 Monday – Friday and from 9 – 5 most days for some assistance. I am also available by appointment at most other times of the day with advance notice.
Property Insurance Topics
- Homeowners Insurance
- Condo Insurance
- Renters Insurance
- Landlord Insurance
- Mobile Home Insurance