How much is enough? This may be a philosophical question that addresses the excesses of the 80's, but it poses a very concrete dilemma for the real estate operator of the 90's. An oversupply of any "commodity" is expensive to maintain, be it in vacant units or redundant staff. With respect to property insurance, however, it is much more likely to be insufficient coverage rather than "overspending" which will cause the inattentive buyer to find himself out-of-pocket" after a loss.
A Confusion in Terms
As in many professional disciplines, the language of insurance has a mystique of its own, and this can make a proper evaluation of ones portfolio difficult. Terms such as "actual cash value", "co-insurance", and "building ordinance" coverage have been misunderstood for years. The effect of this confusion is best illustrated in a real life example. You might want to take out your calculator.
Enough Insurance for What?
Recently Harry Herter's 60-unit apartment building in Queens suffered extensive fire damage to the roof. The repairs and replacement were estimated at $600,000. In addition, a portion of the roof which was undamaged by the fire but judged to be structurally unsafe had to be taken down by order of the city at a projected additional cost of $75,000. Imagine Harry's shock when the insurance carrier's adjustor advised him that his recovery would be approximately $319,000. Here are some of the clues to this sorry mystery: Harry miscalculated the value of his building, didn't buy enough insurance and rejected the offer of a very important optional coverage endorsement.
Actual Cash Value
This term, simply put, serves to value a building at what it would cost to repair or replace the property at current-costs of labor and materials less physical depreciation based primarily upon age and condition. Referred to by insurance people as "ACV", this term is not defined in any policy, nor does any policy recite what elements of physical depreciation will be used, or what percentage will be deducted. Attoday's construction prices, it would cost $2.34 million to replace Harry's property. Let's now assume 30 percent as the depreciation factor and, therefore, deduct $702,000.
We are left with $1,638,000 as actual cash value for insurance purposes. As can be readily seen, this calculation has nothing to do with book value, market value, or assessed value for tax purposes. The operative word is "physical", and Harry, as we shall soon see, has a problem here.
In major medical insurance, co-insurance is simply the/portion of the claim you pay after the deductible. In fire insurance, it's Much trickier. Some background: the social goal of all insurance is to spread risk. For this to work, each potential claimant must pay a premium which fairly reflects the exposure to loss which he asks his neighbors to share with him. Based purely on value, forgetting for the moment any other construction or occupancy factors, a $2 million building presents a much greater exposure to even a partial-loss than a $200,000 building-across the street. Co-insurance is the tool used to level this part of the playing field. The usual figure is 80 percent. In plain English, the policy says that, in order to collect in full on a partial loss, the $2 million owner must purchase at least $1.6 million in coverage, and the $200,000 owner, $160,000. Harry's problem just got worse, but wait.
Building Ordinance Coverages
The broadest coverage language available in a property policy usually includes the term "all-risk". Rather than listing covered perils such a fire, windstorm, explosion, etc. the "all-risk" policy says, in effect, anything that happens is covered unless
the policy excludes it. Of course, no policy is really that simple or unconditional. But the "all-risk" language does shift the burden of proof to the carrier to show why a claim is not covered instead of the policyholder having to show why it is.
However, the language doesn't stop at "all-risk"; it goes on to add". of direct physical loss or damage." It is not unusual after a fire in the New York City area for enforcement of a local ordinance to require modernization to current code specifications or demolition of remaining sections of a building not directly damaged by the peril that occurred. This type of additional cost is not covered by the standard property policy. We are beginning to understand Harry's deepening gloom.
Some Fuzzy Thinking
When Harry renewed his insurance policy, he confused some important issues. Discouraged with the state of the economy and the real estate industry in particular, he reasoned that his building, fully depreciated for tax purposes and with too many vacancies, simply wasn't worth what it used to be. If it were completely destroyed by a fire, he certainly wasn't going to replace it - he'd retire.
In any event, he had to economize, and $1 million seemed like a nice round number for ACV insurance. And he wasn't interested in any bells, whistles, or "ordinances" on the policy. So now we can quantify this faulty logic.
How Much is Enough?
Today's cost to replace building $2,340,000
Actual Cash Value (at
30% depreciation $1,638,000
Amount of ACV insurance required by 80% clause $1.310,000
Amount of insurance Harry purchased $1,000,000
At this point we can see he purchased only 76% of what he should have to collect in full even on an ACV basis ($1 million divided by $1.310,400=76 percent).
Now let's look at the loss: Cost to repair and replace direct damage to the roof $600,000
Cost of city-ordered demolition
Coverages, the $75,000 demolition cost is not covered at all. Next, since he bought only ACV insurance, the value of the $600,000 replacement work will also be reduced by the same 30X factor, leaving $420,000 "collectible". But remember, Harry didn't fulfill his co-insurance requirement-he only bought 76 percent of what he should have. You've probably guessed by now that he will only collect 76 of the depreciated value of the repair cost, or $319,000.
Note: for purposes of this illustration, the nominal policy deductible would have little impact, so we've ignored it.
The sad irony is that none of this had to happen. Competitive pressures have made insurance companies very liberal and flexible in negotiations for coverage. "All-risk" insurance can be readily purchased on a replacement cost basis with no depreciation, and for property owners willing to insure up to a realistic current day physical value, the coinsurance "penalty" clause can be waived entirely and replaced by an "agreed amount" endorsement. What's more, the various important Building Ordinance Coverages are available in some programs for free.
Get the Straight Story
No insurance decision is simple. Even the most basic coverage contract has confusing conditions. Claims settlements are frequently based on practices which are not defined or set forth in the policy at all. There is not substitute for expert help from a knowledgeable agent or broker, and now is an especially good time to obtain broad, reasonably priced protection.
Next month: A smile won't be your umbrella.
An account executive with Kaye Insurance Associates, Marc Cohen specializes in Kaye's comprehensive multi-peril insurance program especially designed for residential real estate properties. Kaye Insurance Associates is one of the largest brokerages in the nation.