Replacement cost coverage is designed to protect a policyholder who has an insured loss from having a reduced financial recovery due to depreciation of the damaged property. Replacement cost coverage will pay the costs to repair or replace damaged property by a covered cause of loss without a deduction for depreciation.
For a number of years, replacement cost was provided on a guaranteed basis — meaning that if the replacement costs exceeded the limits, the company would pay. Today there are a few companies that still offer homeowners policies and business owners policies with replacement cost on a guaranteed basis. The majority offer replacement costs on an extended basis that restricts the amount the company will pay to 25 percent to 50 percent above the policy limit.
While the coverage seems to contradict the principle of indemnity — by enriching rather than restoring — most professionals in our business understand that correctly administered replacement cost coverage works to the advantage of both the insured and the insurer. Less established, however, is understanding how to handle replacement cost adjustments. Some of this lack of
understanding is due to the fact that the coverage is relatively vague.
The term "replacement cost" is not defined under the definitions of standard commercial property and homeowners insurance policies.1 Words not defined within the policy are interpreted by their ordinary,
plain and usual meaning. Courts have ruled that policy language should be interpreted in the manner that an average person would understand it.2
Misconceptions and ambiguities exist. The intent of this article is to clarify some of them — by discussing replacement cost coverage from a claims perspective!
Enrichment vs. Restoration
The principle of indemnity as applied to insurance holds "the policy should not confer a benefit greater in value than the loss suffered by the insured."3 It is to restore the insured to the conditions they were in prior
to the loss. Since damaged property can most often only be replaced with new, one might feel that an insured actually benefits by getting new property in place of old. It was out of this concern — to be consistent with the indemnity requirement — that the concept of depreciation was established.4
Replacement cost coverage does
not unjustly enrich the policyholder for three important reasons. First,
the loss is fortuitous to the insured, thus neither foreseen by nor deliberately caused by the insured. Second, prior to the loss the
property was providing a functional service for the insured and by replacing the item, the insured is being returned to the same position. Third, the insurer is compensated
for the additional coverage granted because premiums are based on the higher replacement cost values rather than the lower actual cash values.
Please bear in mind that in the examples cited, the policy's limit
of liability is always the maximum
level of recovery for the insured.
Also note that we have not
considered "guaranteed replacement value," which may permit a recovery that exceeds the stated limit of liability.
180 Day Requirement
A common misconception involving replacement cost coverage is that the insured has 180 days to make repairs. This is not the case! When a loss occurs the insured can request a payment based on the actual cash value (ACV) and still retain the option of replacement cost. To keep the