Topics covered:

Overview

Building amount

Building laws

Building laws and total losses

Household appliances

Cosmetic losses

Procedure

Replacement requirement

80 percent requirement

Difference illustrated

Personal property endorsement

Personal property valuation

Overview

The effect of replacement cost coverage is to change the method of recovery for loss on affected, covered property from actual cash value to the actual cost of replacement. Actual cash value (see Actual Cash Value) is most often defined as replacement cost less depreciation. An adequate amount of insurance on a replacement cost basis eliminates the deduction for depreciation.

 Before going any farther in this discussion, a definition of the word "replace" or "replacement" is necessary. A standard desktop dictionary says that "replace" means "to put something new in the place of." An even better definition comes from The Dictionary of Real Estate Appraisers: "The estimated cost to construct, at current prices, a building with utility equivalent to the building being appraised, using modern materials and current standards, design, and layout." Replacement cost insurance, then, provides a new item for the damaged or destroyed one. This concept was clarified in Great Texas County Mut. Ins. Co. v. Lewis, 979 S.W.2d 72 (Tex. App. Austin 1998). Here the court said that the words "repair" and "replace" mean "restoration to a condition substantially the same as that existing before the damage was sustained."

 Building Amount

 Adequate amount of insurance must be considered from two angles. First, to be fully protected the amount of insurance must be equal to the potential maximum loss; any amount less will be inadequate to cover a total loss. The offering of guaranteed replacement cost by means of a non-ISO endorsement that overrode the limits of the policy is no longer as popular as it once was. Carriers found that they were paying for coverage well above what had been contemplated for in premiums charged. In 1994, ISO introduced two optional endorsements—HO 04 20 05 11, Specified Additional Amount of Insurance for Coverage A—Dwelling (to be used with forms HO 00 02 05 11 and HO 00 03 05 11 only), and the HO 04 11 05 11. Additional Limits of Liability for Coverages A, B, C, and D (forms HO 00 02 and HO 00 03 only). These two endorsements are reviewed below, since they operate differently from many guaranteed replacement endorsements in use today. The HO 04 11 and HO 04 20 were reissued in 2011 with no changes.

 When purchasing guaranteed replacement cost, the insured agrees to insure the home to 100 percent of its replacement cost, instead of 80 percent. Also, the insured agrees to accept whatever annual increases in value the insurer may deem necessary, to keep the coverage at 100 percent of replacement cost. Then, in the event of a total loss, the insurer promises to replace the home exactly as it was, regardless of the cost involved—even if the cost goes over the amount of insurance listed on the policy. Note that the terms guaranteed replacement and replacement are not the same. Replacement means the insurer will replace or repair within the terms and limits of the policy; guaranteed replacement means the policy limits will be modified at the time of a loss.

 To be eligible for replacement cost recovery, even on losses involving only outbuildings, the amount of insurance on the building has to be adequate to equal at least 80 percent of the cost of replacing the structure just prior to the loss. For example, if replacement cost of the dwelling as it stands before the loss amounts to $100,000, the amount of insurance must be at least $80,000 if the insured is to have full replacement cost recovery on any loss up to $80,000. (This requirement may be adjusted downward to 50, 60, or 70 percent by means of endorsement HO 04 56 05 11. Such an adjustment, however, makes for a substantial reduction in the amount of homeowners coverage with only a minimal reduction of homeowners premium so it is not likely to be widely used.)

 The replacement cost language also lists certain property that is to be disregarded in determining whether the 80 percent requirement has been met. This is not to say that the property is excluded from replacement cost recovery if loss or damage falls within policy coverage; its value simply need not be taken into account in measuring compliance with the mentioned requirement. The list consists of the cost of excavation; underground flues, pipes, wiring, and drains; and foundations, piers and other supports below the lowest basement floor, or, where there is no basement, below the surface of the ground inside the foundation walls.

 ISO has two optional endorsements to provide guaranteed replacement up to a certain amount. The HO 04 20, in event of a loss to the dwelling exceeding the coverage A limit of liability shown in the Declarations, makes an additional amount of insurance (either 25 percent or 50 percent of the declared coverage A limit) available. For this added protection, the insured agrees to insure the dwelling at the full replacement value (in accordance with property valuations made by the company and any increase in inflation), and notify the company of any additions, improvements, or alterations that increase the replacement cost of the dwelling by 5 percent or more. Loss settlement will then be no more than the smallest of the replacement cost of the part of the dwelling damaged or destroyed, the necessary amount actually spent to repair or replace the damaged or destroyed dwelling, or the limit of liability plus the additional amount provided by the endorsement.

 Endorsement HO 04 11 provides, when a covered loss to the dwelling exceeds the coverage A limit of liability, for additional limits of liability for coverages A, B, C, and D. Again, the insured agrees to insure to value and notify the company in event of any improvements or betterments increasing the replacement cost by 5 percent or more. The 2011 form specifies that the carrier be advised of changes to Coverage A of 5 percent or more, not just the dwelling building. Then, in event of a loss, the coverage A limit is increased to equal the current replacement cost of the dwelling, and coverages B, C, and D are increased by the same percentage as applied to coverage A. If coverage A is adjusted by 10 percent, then coverages B, C and D will be adjusted by 10 percent. The policy premium for the remainder of the term is adjusted based on the increase. Loss settlement will then be no more than the smallest of the replacement cost of that part of the building damaged or destroyed, the necessary amount actually spent to repair or replace the damaged or destroyed building, or the limit of liability in accordance with the endorsement's provisions.

 The replacement cost coverage of homeowners and dwellings forms applies only to buildings—the dwelling and private building structures—and parts of building structures. However, the mere fact that a piece of property falls within the form's description of building does not mean that it is insured on a replacement cost basis. There is a specific list of restricted property: carpeting, awnings, household appliances, outdoor antennas, and outdoor equipment, all whether attached to the building or not. Recovery on these items remains at actual cash value.

 Building Laws

 Many communities require that after a home suffers a certain percentage of loss or damage it must be rebuilt according to the current building codes. Thus, aluminum wiring must be replaced with copper; knob and tube wiring must be replaced with circuit breakers; 1/2 inch-diameter water lines must be replaced with at least 1-inch lines; etc. Unfortunately for the homeowner, the standard policy does not include such costs as part of the replacement cost settlement.

 The 2000 and 2011 versions of the homeowners policy go a long way in this direction. They provide, as an additional amount of insurance, up to 10 percent of the dwelling limit for such upgrades. This is additional coverage 11 Ordinance or Law. The insured may also use that amount to pay extra debris removal expense associated with making those code upgrades. Loss of property value because of code upgrades is not covered, nor is the cost to test for, monitor, clean up, or in any way respond to pollutants in or on any covered building or structure.

 Building Laws and Total Losses

 What happens when an insured faces a total loss as the result of the operation of a building law? Insurers have traditionally held that the hazard insured against (e.g., a fire) only caused a partial loss and that the insurer should not be held liable for the extra part of the loss that resulted from the enforcement of a building law. Typically, courts have come down on the side of the insured.

 The seminal case in this area is Larkin v. Glen Falls Ins. Co., 83 N.W. 409 (Minn. 1900). Although over 100 years old, the case has never been overturned. In Larkin the insured's building was partially destroyed by a fire. The local code prohibited rebuilding the structure. Thus, the court ruled that the insured was entitled to recover for a total loss, less any salvage value – rather than the cost of repairing the building in full settlement of the policy.

 Other policies have built in exclusions for code upgrades, and these exclusions have been supported by various courts. In Roberts, v. Allied Group Ins. Co. 79 Wash.App. 323, 901 P.2d 317 Wash.App. Div. 1, 1995 the insured sued his homeowners carrier for replacement cost including code upgrades after the house burned. The court held that the carrier's limitation on the guaranteed replacement cost endorsement for increased construction costs due to code changes was valid.

 Household Appliances

 While the homeowners policy settles losses to the dwelling at replacement cost, losses to household appliances—even those that are built-in—are settled at actual cash value. The meaning of household appliances in this restriction continues to be debated from time to time. Is a water heater, a furnace, or an air conditioning system a household appliance? The term lends itself to application to such items, for they are of the household and they are appliances. However, the purpose of the original drafters of the language is said to have been the elimination from replacement cost recovery of items that are routinely replaced in most households. Such items may have a short life span; new and improved models may come on the market with regularity; and their low cost relative to structural items encourages their replacement routinely. Food blenders, processors and mixers, portable air conditioners, free-standing stoves and refrigerators, microwaves, washers and dryers, are all examples of household appliances for the purpose of this replacement cost coverage restriction. Even if appliances are attached to a shelf or hung on a wall, and thus perhaps technically part of the dwelling structure, they are not covered for replacement cost.

 Many, if not most, insurers and their adjusters use as a rule of thumb in determining what constitutes a household appliance, the two factors of the necessity of the item to the integrity of the dwelling as a place to live, and the necessity of the item to the structural integrity of the building. For example, a household appliance such as a furnace or a central air conditioner equips the structure to serve as a place of abode, and a built-in cook top, the removal of which would leave a gaping hole in the kitchen counter, is necessary to the structural completeness of the dwelling. Recovery for loss to these items (and other similar items) on the basis of replacement cost is usually allowed.

 In Armstrong v. Farmers Ins. Co. of Idaho, 147 Idaho 67, Supreme Court of Idaho, April 2, 2009 the court stated that a household appliance as used in everyday language refers to items such as toasters, food processors, electric can openers and similar items that are used to perform a specific function – toasting, cutting, opening cans. The item must be used to perform a specific function.

 Cosmetic Losses

 Another question that evades an industry-wide conclusion has to do with what has been called cosmetic losses, i.e., when replacing the damaged part of a structure leaves mismatching colors or textures because new materials identical to the old are no longer available. Roof coverings and kitchen cabinets figure most often in such dilemmas; one half of a roof may have to be replaced, for example, but the new shingles are in jarring contrast to the undamaged shingles on the other half of the roof to the obvious detriment to the overall value of the property. The insured will argue that the entire roof must be replaced, otherwise the insurance company has failed in its mission to restore him to his preloss position. The insurance company may contend that its obligation is to cover property that has been physically damaged, seeing the matter as loss and restoration of individual shingles rather than loss to a roof.

 The ISO homeowners and dwelling loss settlement provisions state that the insurer will not pay more than "the replacement cost of that part of the building damaged for like construction…" Since there is no limiting provision in the policy contract, nor is there any definition as to what constitutes a part of the building, many (including the editors) are of the opinion that the insured is, as is customary, entitled to the benefit of the doubt.

 It has been suggested that the loss to a pair or set clause might be invoked in the instance of damage to kitchen cabinets, allowing the insurer to pay the difference between actual cash value of the property before and after the loss should it prove impossible to obtain new cabinets in the style of the remaining, undamaged, old ones. However, the loss is one of damage to part of a structure, the installed cabinets, and the policy promises replacement cost, not actual cash value, on covered structures.

 Courts have come down on both sides of the matching issue. In Holloway v. Liberty Mut. Fire Ins. Co. 290 So. 2d 791 (La. Ct. App 1974) the court ruled that where replacement of undamaged property was necessary to achieve an aesthetically pleasing repair and prevent devaluation of the property, then an entire replacement is in order.

 On the other hand, Weiler v. Union Ins. Co. 2006 WL 2403935 (not designated for permanent publication) stated that when hail damaged one side of the insured's house and the replacement siding could not be matched to the siding on the other sides, the court ruled that only the damaged side should be replaced, that the policy was clear on that language.

 A case in the Fourth Judicial District of Minnesota clearly comes down on the side of the matching requirement—even going so far as to require the replacement of undamaged property if it cannot be matched. That case is State of Minnesota, v. American Family Mut. Ins. Corp.

 American Family insured many homes that suffered hail damage in 1998. The damage was to siding and roofs. When the insurer settled the claims, it paid only for those parts of the home that actually had been physically damaged. This led to complaints from the homeowners to the state. The court summarized the complaints as follows: "replacement of only the directly damaged parts of [their] homes results in mismatched materials in situations where the siding and/or roofing on the policyholder's home is no longer manufactured or is otherwise unavailable."

 The court went on to note that the American Family policy promised "full replacement costs, without deduction for depreciation." It continued: "Nothing in American Family's policies limits the insurer's obligation, excludes coverage, or otherwise supports American Family's practice of limiting payment under replacement value provisions of its policies to sums necessary to replace only the portion of policyholder's dwelling that is directly damaged by a covered peril."

 The court ordered that matching materials be provided. It said that it was "not satisfied by the replacement of only those materials that are physically damaged by a storm, if the replacement materials do not or would not reasonably match in terms of color, quality, texture, or type of material the existing materials on the policyholder's home." Further, "American Family must also pay the sum necessary to replace the existing materials so there is a reasonable match, except where the mismatch is attributable to the natural weathering of existing materials."

 Mutual Services Offices (MSO) clearly spells out in their policy what they will pay for. The MPL01 common provision form states that the carrier covers the "reasonable cost to match the damaged portion as closely as possible to the undamaged portion. We are not liable for replacement of the undamaged portion." This leaves no confusion; the carrier will only pay for what has been damaged, and will leave the property mismatched.

 Because this issue is so difficult, many states have specific statutes addressing matching of property and what must be replaced. See Matching Statutes by State.

 Procedure

 Following a loss that is subject to the replacement cost provision, the insurance company must pay the smallest of these three amounts: the policy limit applying to the damaged property; the amount the insured actually spends in repairing or replacing the damaged structure; or what it would cost to restore the property on the same site using equivalent construction and for equivalent use.

 These limitations on the amount of recovery do not directly limit the insured to same-site repair or replacement. If an insured wanted to effect replacement by means of purchasing a substitute dwelling at another site, that option is open—but the insurance company is not required to allow a greater loss settlement than what would have been the cost of making restoration on the same site. Obviously, salvage of the remaining portion of the structure at the old site would have a bearing on the loss settlement also. Editors have been asked if the cost to repair a new dwelling at a different location can be included in the loss settlement. For example, the insured dwelling had a wooden floor and the proposed new dwelling has linoleum. The insured wants to replace the linoleum with a new wooden floor, since that is what the original dwelling had. However while a replacement home can be purchased at a different location, the policy is still paying for the loss of the insured dwelling, not the cost to modify another dwelling. No more than the amount to replace the insured dwelling is covered. The insured could replace the insured dwelling at the original location, or could buy a new home with wooden floors.

 In Conway v. Farmers Home Mut. Ins. Co., 26 Cal. App. 1185 (4th Dist. 1994), the court held that the policy provisions did not require repair or replacement of an identical structure on the same premises, but rather set the rebuilding amount as a measure of damages in calculating liability under the replacement cost coverage.

 Replacement Requirement

 The insured cannot collect any amount above the actual cash value of the damaged part unless and until actual repair or replacement is completed. The insured can submit a claim for actual cash value immediately and collect any additional amount available under the replacement cost coverage later, subject to a requirement that the additional claim be made within 180 days after the loss.

 Timely notice from an insured that a claim for replacement cost recovery is to follow the actual cash value settlement is ordinarily sufficient to meet the 180-day requirement. The Maine supreme judicial court was asked to review a lower courts decision on this point and it determined that there is "simply no support" in policy language for the insurer's contention in that case that the claim had to be completed within 180 days. The case is Blanchette v. New York Mut. Ins. Co., 455 A.2d 426 (Me. 1983).

 In another case, the Maine supreme judicial court said this about the 180 day requirement: "The pertinent clause of the policy merely provides a procedural mechanism for an insured who may make a claim based on actual cash value, and later make an additional claim on a replacement cost basis, if such claim is made within 180 days of the additional loss." See Maine Mutual Fire Ins. Co. v. Watson, 532 A.2d 686 (Me. 1987).

 Although most contractors will work with a homeowner and replace the home for the ACV settlement, with the promise of the balance after payment by the insurer, such an agreement is not mandated. Even in cases where the insured cannot obtain a loan for the difference between replacement cost and the actual cash value payment, the insurer does not owe an amount greater than the ACV of the loss until actual replacement is completed. (See Hilley v. Allstate Ins. Co. , 562 So. 2d 184 (1990)).

 There is one exception to the requirement that repairs be made before collecting the replacement cost part of the loss. It applies when the loss is no more than $2,500 and no more than 5 percent of the whole amount of insurance applicable to the building structure. However, even a small loss calls for a computation to see whether the insured is to recover fully, only at actual cash value, or at some figure between the two by virtue of the provision next discussed. Note that under the MSO forms, the actual repair must be accomplished within the 180 days, putting more of a burden on the insured.

 80 Percent Requirement

 The ideal and least complicated application of replacement cost coverage is possible when the amount of insurance at the time of loss is at least 80 percent of the full replacement cost of the damaged building. In this case, the loss is paid up to the amount of coverage without deduction for depreciation. If, however, the amount of insurance is less than 80 percent of the replacement cost of the damaged building, recovery (up to the amount of insurance) is limited to the larger of two figures:

 1.the actual cash value of that part of the building damaged or destroyed; or

2.that proportion of the cost of repair or replacement of the damaged or destroyed part of the building that the whole amount of insurance applicable to the building structure bears to 80 percent of its full replacement cost.

 Difference Illustrated

 In a real sense, the insured cannot be harmed by the presence of the replacement cost coverage; it is an improvement over basic protection. Unlike the coinsurance provision in forms for commercial property that has affected insureds adversely in the past, the homeowners or dwellings forms provide that the insured cannot collect less than would have been available on the loss without the replacement cost provision.

 To illustrate, suppose that a dwelling insured under a homeowners policy written for $70,000 has an actual cash value of $80,000 and that its full replacement cost is $100,000. There is a fire and it is agreed that the actual cash value of the damaged part is $40,000. The repairs will cost $50,000.

 The amount of insurance is adequate to cover the cost of repair. The question therefore is, can the insured recover more than actual cash value on the repairs? The recovery will be the larger of the actual cash value of the damaged part ($40,000) or that proportion of the replacement cost of the damaged part ($50,000) that the amount of insurance ($70,000) bears to 80 percent of the full replacement cost of the building (80% of $100,000, or $80,000). The latter works out to $43,750—70,000/80,000 x $50,000—so the insured collects $3,750 above and beyond the $40,000 actual cash value of the damaged part.

 Personal Property Endorsement

 For an additional premium, homeowners insureds may add an endorsement that provides replacement cost recovery on losses of personal property and those building items that are excepted from replacement cost consideration in the basic contract—awnings, carpeting, household appliances, outdoor equipment, and outdoor antennas. The ISO homeowners endorsement is HO 04 90 05 11.

 Use of the endorsement avoids potential arguments on the meaning of household appliances. Four groups of personal property are excluded as not eligible for replacement cost recovery: art objects, memorabilia, broken or not functioning items, and articles that are out of fashion and either stored or held in anticipation of no known use.

 The fourth category applies to, for example, used clothing of no particular significance stored in an attic. It would not apply to such things as clothing of a particular period that the insured held in attic storage in anticipation of costume party usage, or baby clothes and furniture that will be passed on to grandchildren. The incidence of property that is both out of style or fashion and also out of use permanently is not apt to be great.

 Property in categories one and two will often be valued at replacement cost regardless of the endorsement. That is, the actual cash value of an art object or a collectors item is frequently determined by its market value so recovery of a sum comparable to market price will leave the insured with a recovery tantamount to replacement cost. Of course, items of significant value are apt to be scheduled and thereby removed from the considerations applicable to unscheduled personal property, including the replacement cost provisions of the endorsement.

 The endorsement provides replacement coverage on the following if separately described and specifically insured in the policy: jewelry, furs, cameras, musical instruments, silverware and goldware, and golfer's equipment. However, the endorsement also specifies that replacement cost coverage does not apply to any other property that the insured may have scheduled separately.

 Personal Property Valuation

 Replacement cost coverage on personal property is not tied to or dependent upon any relationship between the amount of coverage C (personal property) and actual replacement values. Use of the replacement cost endorsement has no effect on the overall limit applicable to coverage C, nor does it affect scheduled property (except as noted) or the various internal limits applying to certain classes of personal property, i.e., jewelry, silverware, firearms, etc. However, so long as none of these limitations pertain, recovery on insured personal property losses (as well as carpeting, awnings, etc.) will be the cost of repair, the cost to replace, the limit of liability applicable to coverage C, any applicable special limits of liability stated in the policy, or the limit of liability applying to any item separately described and specifically insured.

 Endorsement HO 04 90 is silent as to its effect on the policy's loss to a pair or set clause. The two might be seen as being in opposition. The endorsement promises replacement cost recovery but the clause says that whenever there is loss to items that are parts of pairs or sets, the insurance company has the option of paying the difference in the actual cash value of the pair or set after the loss as compared to before. This has led to a question respecting, for example, a set of books in an encyclopedia. If half the books are destroyed in a fire, is the insured entitled to recovery of the cost to replace the set or only the difference in actual cash value of the old, complete set and the current condition of a partial set? If the insured benefits from recovering on the basis of replacement cost, he or she is entitled to do so. It is traditional in insurance interpretation that the provisions of a modifying endorsement take precedence over conflicting terms in the base contract.

 The insured can recover replacement cost on small losses immediately. When a replacement cost loss—exceeds $500, the insured will recover for the actual cash value of the damaged property. Upon completion of repair or replacement, the insured can make further claim for the difference. The claim for the replacement cost difference must be made within 180 days but this does not mean—see the previous discussion—that all details of the claim have to be completed within that time frame. It is sufficient that the insured gives notice of intent to claim replacement cost recovery within 180 days and proceed with reasonable speed in accordance with whatever rules apply to straightforward dealings to effect the replacement.