Condo Media - February 2013 - 20

ASKED & ANSWERED

Protecting Your Association
Replacement Cost vs. Cash Value

Q
A

QUESTION: What’s the difference
(other than premium cost) between
replacement cost and cash value
insurance coverage for our community association? How do we decide
which is best?
ANSWER: A cash value policy will
pay whatever the insurance company
estimates your buildings were worth at
the time of the loss, taking into
account their age and condition and
depreciation, among other factors. So
a 20-year-old building would have a
lower cash value than an identical 10year-old building. If the cash value
stated in your policy is $500,000, that
amount (minus depreciation and your
deductible) is what the insurer will pay
to repair or replace it.
Replacement value, as the name
implies, will pay what it actually costs
to reconstruct your damaged buildings
today, using materials of comparable
quality. If it cost $1 million to construct your building 20 years ago but
would cost $5 million to build it
today, a replacement cost policy with a
coverage limit of at least $5 million
will pay that amount. So the answer to
your question — Which policy is better? — is easy: replacement cost. A
cash value policy may fall woefully
short of the coverage you need to
repair or replace buildings that have
been damaged or destroyed.
The more difficult but very important question is — If you have a
replacement cost policy, how do you
estimate correctly what the replacement cost is likely to be so you know
how much coverage you will need?
A “guaranteed replacement cost”
policy eliminates the guesswork, guaranteeing to pay the full replacement

CONDO MEDIA • FEBRUARY 2013

cost, whatever it turns out to be.
Unfortunately, this coverage is rare —
few companies offer it and those that
do are extremely selective about the
communities they will insure.
For communities with multiple buildings, a “blanket” policy offers the best
alternative, according to David
Holton, president of The Essex
Agency, Inc. in Essex Junction, Vt. He
explains it this way: If you have 10
buildings with an estimated replacement value of $1 million each, your
coverage limit would be $10 million.
If you suffer a $2 million loss at one
building, you’d have $10 million of
coverage available to cover it. It is
highly unlikely that all 10 buildings
would be destroyed in a single incident
— the only circumstance in which that
$10 million limit might be inadequate.
The disadvantage of a blanket policy,
Holton says, is “you have to accept
whatever value the insurer sets.” Some
less scrupulous agents will intentionally
understate the estimated value in order
to produce premiums that are attractive, but artificially low. For that reason (although it’s not the only one),
you want to work with an experienced
agent you know and trust. You also
want to be sure the policy includes an
inflation endorsement, automatically
adjusting the coverage limit to reflect
increasing construction costs.
A blanket policy is a good solution
for communities with multiple buildings, but it won’t work if you’re insuring a single property. Here, it will be
important to start with a good, baseline estimate of the replacement cost.
Most insurance companies will use a
formula based on construction costs
per square foot. These formulas will
reflect geographic differences, recog-

nizing, for example, that construction
costs will likely be higher in San
Francisco than in Muncie, Ind. But the
industry benchmarks don’t reflect the
differences within geographic areas,
Holton cautions, noting that building
code requirements, permitting expenses and other factors can make it more
costly to build in urban than suburban
locations; construction difficulties and
site differences could make the cost
per square foot higher for different
buildings in the same community.
Instead of relying on the industry formula, Holton recommends that boards
go back to the developer of their community, if possible, and request a formal appraisal of what it would cost to
construct the same building today. If
that’s not an option, he suggests,
boards should ask another developer
who is constructing similar buildings
today to provide an “honest appraisal”
of the likely construction costs.
Communities should have their
buildings re-appraised at least every
five years, Holton suggests (some
industry executives suggest a threeyear cycle), to make sure their replacement cost estimates and coverage
limits are accurate. You will also want
to make sure your policy contains an
inflation trigger (to provide extra protection against rising costs) and an
ordinance or law endorsement, which
will guarantee payment for improvements required to meet building code
requirements that weren’t in effect
when the property was constructed.
You’ll pay a fee for the periodic
appraisals Holton and others recommend, but it will be well worth the
cost to know that if you have a disaster, inadequate insurance won’t create
another one. CM

Condo Media - February 2013

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