How Property Insurance Valuation Works

Choosing a suitable property insurance valuation option helps ensure coverage matches need. Each insurance policy contains a section titled “Valuation” where it defines how property will be valued at the time of a claim. A variety of property insurance valuation options are available. Valuation affects reimbursement – the claim payment. Although policies may offer a large amount of financial coverage, depending upon the type of property insured and your needs, it may make more financial sense to select an alternative valuation method, insure your property for less, and enjoy lower premiums. Each client decides what works best for their situation.

Below are the most common property insurance valuation methods.

Replacement Cost

Replacement cost is the most popular property insurance valuation method. It covers the cost to repair or replace a building with materials of the same or comparable quality; replacing old with new. Replacement cost does not include the value of any land and is determined based on the amount needed to hire contractors and purchase materials to repair a building or construct a replacement.

Theoretically, the replacement cost of a commercial property should be lower than its market value, since the replacement cost only has to take building materials and labor into consideration. However, market values fluctuate, as do the costs of materials and labor. Thus, at times, replacement cost of a property can be higher than its market value.

Replacement cost offers a large amount of financial protection since it does not take depreciation into account. It is the most popular valuation option. It best restores you to the financial position before the claim. However, it is usually more expensive than other valuation options and may not make sense for every property.

Actual Cash Value

Actual cash value is another popular property insurance valuation option. This method functions in a similar manner to replacement cost in that it considers the cost to repair or replace a property. However, a deduction is made to the valuation to account for depreciation to the original property. Think of actual cash value as being replacement cost minus depreciation.

An actual cash value property insurance policy will still rebuilt or repair the property using modern construction techniques and materials. But since the building value is reduced by depreciation, it allows a client to insure their property for less. The client will receive less for their claim as well.

We typically see the actual cash value property insurance valuation option work better with businesses that do not need their building to be rebuilt as-is. Building owners of older buildings with expensive building methods may benefit from actual cash value if they would prefer rebuilding using less expensive methods. Actual cash value policies generally have lower premiums than replacement cost plans.

Claim Examples

Suppose you are a manufacturing business that occupies an old car dealership downtown. The building is solid masonry, much of the first floor is covered in marble, and the roof is slate. Should your building be destroyed by fire, it would cost Rs. 1,000,000 to replace it with the same building materials and methods.

• Total Loss Scenario: Suppose a fire destroys the building. If you insured the structure for Rs. 1,000,000 replacement cost, you would receive Rs. 1,000,000. If you insured it for Rs. 700,000 actual cash value, you would receive Rs. 700,000. Although you receive less with the actual cash value property insurance valuation option, you also pay less for insurance premiums.
• Partial Loss Scenario: Suppose the fire only damages the roof and that repairs will cost Rs. 50,000. If insured at replacement cost, you will receive Rs. 50,000 to repair or replace your roof. However, if insured at actual cash value, the amount you are paid depends upon how old the roof was since depreciation is a factor. If the roof was 50 years old, at the end of its life cycle and in need of replacement already, you would receive very little for the claim. However if the roof was brand new when damaged, you would receive full value.

Functional Replacement Cost

Another cost-effective property insurance valuation option is functional replacement cost. Though not often utilized, it provides a great degree of flexibility and cost savings. This valuation method is used when a functionally equivalent building can be built at a lower cost to replace the original property. A building’s functional replacement cost is lower than the replacement cost, which results in a reduction in the amount of coverage needed and therefore smaller premiums.

Functional replacement cost can also be used to repair a partially damaged property with less expensive materials, such as replacing a wall with drywall instead of plaster. Or consider our partial loss scenario above. Functional replacement cost would cover the entire cost to replace the roof, but with functionally equivalent material such as modern shingles instead of slate.

The main reason for using functional replacement as your property insurance valuation option would be to save money. Similar to actual cash value, it may be a good option for properties that have expensive materials that are not necessary to the function of the property. However, functional replacement cost does not take into account depreciation, a nice benefit over actual cash value.

Agreed Value

Though one of the simplest methods of valuation, it can be difficult to obtain. Many insurance companies simply don’t offer it. However, when available, it is worth consideration. In its simplest form, the building owner and the insurance company agree what the structure is worth before the policy is put in place.

As an example, consider an old church with oak pews and large stained glass windows. Value can be difficult to establish. By arriving at an agreed value ahead of time, the question is settled before a claim occurs. Thus, co-insurance does not apply.

Market Value

Market value is rarely offered as a property insurance valuation option, but often referenced to determine which valuation method is most appropriate. Simply put, market value describes the estimated amount that a property would sell for on the date of valuation. Any land included in a commercial property is also a part of the market value. The terms market value, open market value, fair market value, and fair value are used interchangeably.

A number of factors are considered when a property’s market value is appraised. These include location, capitalization rates, rent growth rate, the general state of the real estate market, and others. Market value is most often referenced when buying or selling a property.

In Summary:

• Replacement Cost: Most widely used. The cost to replace or rebuild using the same materials. No deduction for depreciation.
• Actual Cash Value: Second most popular. Defined as replacement cost minus depreciation.  Allows a building to be insured for less than replacement cost, but can be problematic with partial loss (hurricane blows off all shingles on a roof which are ½ way through life cycle, therefore ½ depreciated, therefore claim pays ½ of roof replacement).
• Functional Replacement Cost: Cost to rebuild with lower priced, modern methods and materials.
• Agreed Value: Rarely available. Building owner and insurance company agree on building’s value before the policy is put in place.
• Market Value: Rarely available, but a useful reference. The estimated amount that a property would sell for on the date of valuation.