FUNCTIONAL REPLACEMENT
COST VALUATION
(May 2025)
Property the American
Association of Insurance Services (AAIS) Businessowners Policy insures is
valued at either actual cash value or replacement cost value. There is a
significant penalty if a loss occurs and the property is not adequately insured
to value. However, certain buildings and business personal property should not
be insured to their replacement cost (or even their actual cash value) because
doing so could create a significant moral hazard.
Functional replacement
cost is used when it’s not practical or cost-effective to replace damaged
property with materials or methods identical to the original. Instead, the
property is replaced with materials or construction that serve the same
function but may be less expensive or more modern.
To address this, AAIS
has developed two endorsements offering alternatives, allowing the named
insured to adjust the amount of coverage to align with the expected cost of
replacing damaged property.
BP
0345–Functional Replacement Cost Valuation–Buildings
This endorsement is
applicable when the named insured owns a building but does not fully utilize
it. In the event of a significant loss, the named insured would opt to replace
it with a smaller and less ornate structure. For example, consider a multi-story
building where the named insured only uses the lowest floor. If a significant
loss occurs, they would choose to replace it with a smaller, one-story
building.
Similarly, in the case of an office
building with elaborate decorations, the named insured would replace it with a
much simpler design if a significant loss were to happen.
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Example:
Helen owns a
four-story building located in the downtown area. The first floor houses her
retail hosiery shop, while the second floor contains the offices, an employee
break room, a locker room, and the Internet sales division. Helen rents the
top two floors for herself, where she occupies her apartment. The building is
constructed of poured concrete and features ornate decorative elements on the
street-facing wall. The current cost to replace this building with one that
has similar features is over $3,000,000, due to the type of construction and
the craftsmanship required to recreate such intricate details. However, Helen would prefer to replace it
with a more economical two-story structure made of solid masonry materials,
rather than replicating the existing construction and decorative features. |
BP
0343–Functional Replacement Cost Valuation–Business Personal Property
This endorsement may be used when
machinery, furniture, or fixtures can be replaced with functionally similar
items at a significant savings. Although the existing property may have value,
it may not be efficient. For instance, an office filled with ornate carved
desks and bookshelves could be upgraded to more practical workstations and
alternative filing systems.
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Example: Julie is a fourth-generation lawyer in the
Kendrick-family law firm. She owns the firm and has always enjoyed the fine
wood furnishings. However, all law journals are now online, and she does not need many of the bookshelves scattered throughout the premises. Her desk is
beautiful, as is every desk in the office, but it is not practical for the
type of law the firm practices. The cost to replace the furnishings is
$500,000, but she could easily replace everything with more functional
furnishings for about $200,000. |
This endorsement starts
with a schedule containing the following information:
This endorsement is not
a separate coverage form. All terms of the policy apply, except for those
modified or changed by this endorsement.
The following is a
summary of the changes and modifications:
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Example: Jerry’s six-story building is situated in a
downtown area. Its market value is $3,000,000. However, it is worth only $1,000,000,
but the land is worth $2,000,000. |
The terms " replacement cost” and “actual cash value” are deleted and replaced by the following Functional Replacement
Cost valuation.
Total Loss rebuilt on the same site:
Total Loss rebuilt on a different site:
Payment
is for no more than the amount the named insured actually spends to rebuild and
to demolish and remove debris.
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Example: Peter’s Stationary has a
total loss. Peter spends $200,000 to replace the building. This is
significantly less than the structure’s $2,000,000 replacement cost. |
Partial Loss to the
building:
·
If
the loss is partial and the named insured signs a contract to repair the
damaged building within 180 days after the incident, the valuation will be
based on the cost to repair or replace the damaged portion with materials
similar to those used in the rest of the building, provided they are less
expensive. This valuation will also include the cost of removing debris from
the damaged building.
The payment will not
exceed the actual amount the named insured spends on repairs, demolition, and
debris removal.
It's important to
understand that if a signed contract is not in place within 180 days after the
loss, and the insurance company has not agreed to an extension—either total or
partial—the maximum amount paid will be the lesser of the property's market value
on the date of loss or the cost to repair or replace the building with similar
materials of lesser cost. This provision requires that the cost to repair or
replace takes depreciation or deductions into account due to physical
deterioration.
·
Under
Property Coverages—How
Much We Pay—this endorsement eliminates 3.b. for the costs to
rebuild with like kind and quality because it is not relevant to Functional
Replacement Cost Valuation.
·
Under
Property Coverages—How Much We
Pay—this endorsement modifies the
provisions by adding Functional Replacement Cost valuation terms.
This endorsement
replaces (7. Increase Costs – Ordinance or Law) the previous coverage with a
more comprehensive version. In addition to covering the increased costs, it now
also includes the value of any undamaged building that needs to be destroyed,
as well as the costs for demolition and debris removal.
It's important to note
that there is no additional insurance amount for any of these Increased Costs
coverages unless a specific limit of insurance is specified in the endorsement
schedule.
This section works with
the direct damage coverage that Increased Costs–Ordinance or Law provides. It
covers the increased amount of time needed to comply with those ordinances or
laws by changing the definition of the Period of Restoration to eliminate the
paragraph that does not permit any additional time because of laws or
ordinances. Also, a further provision has been added for pollution or fungus
that does not increase the time of restoration due to code enforcement or
regulation for replacement, remodeling, rehabbing, or razing of property.
Another feature of this
change is the 72-hour waiting period for loss of earnings can be reduced by entering
a different time period or eliminated by entering “none” in the space provided on
the endorsement schedule.
Lastly, the loss or
damage must occur at the described premises.
This endorsement starts
with a schedule that requires entering the Premises Number, Building Number, a
description of the business personal property, and the functional replacement
cost Limit of Insurance for that property.
It is important to note that all other
business personal property may be valued
on a full replacement cost basis, and only one item or type of property changed
to functional replacement cost.
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Example: The tables and chairs at Millie’s soda shop are 75
years old. The cost to replace them is more than Millie wants to pay. She prefers
to purchase readily available tables and chairs instead. She separates the
value of the tables and chairs from her other business personal property
limits and schedules them on BP 0343. She selects a limit of $15,000 to apply
to them instead of the $75,000 replacement cost that would otherwise be
required. |
This endorsement is not
a separate coverage form. All the policy’s terms apply except for the ones this
endorsement modifies or changes.
The following
summarizes those changes:
The term refers to the
competitive price a covered property should bring in the open market when sold
under fair sale conditions. The price of the land must be excluded when
determining this value because the land remains even after a loss.
The terms " replacement cost” and “actual cash value” are deleted and replaced by the following
Functional Replacement Cost valuation.
NOTE: The 180 days can be extended
if the insurance company agrees to do so.
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Example: Peter’s Stationary’s loss
includes business personal property. He spent $10,000 to replace the carved
wooden stock displays valued at $50,000 with more practical and accessible
ones. |
·
If
the insured and the insurance company have not agreed to extend the timeframe
for entering into a contract, and the insured does not enter into a contract
within 180 days, the insurance company will pay the lesser of either the market
value or the cost to repair or replace the BPP with similar quality and type,
minus any physical deterioration or depreciation.
Under Property Coverages—How Much We Pay—this endorsement eliminates
3.b. for the costs to repair, replace, or rebuild with like kind and quality
because it is not relevant to Functional Replacement Cost Valuation.