The whole idea behind insurance is protection. When you buy property insurance for a building, the goal is to have enough coverage so that your insurance claim will put you in roughly the same economic position you were – or as close to it as possible – before disaster struck.
The Three Property Valuation Methods
From an insurance perspective, there are three basic methods for valuing and assigning coverage limits to a commercial property: fair market value (FMV), actual cash value (ACV) and replacement cost. It’s important to understand that these numbers can be very different from each other – and sometimes radically so. The three approaches are not interchangeable at all. It’s very important to understand the type of insurance coverage you own and how claim settlement figures are arrived at.
Fair Market Value
The concept of fair market value is familiar to most of us. A property’s FMV is the price a property would sell for if placed on the market today and purchased by an informed, knowledgeable counterparty in an arms-length transaction. That is, there are no outside influences or competing loyalties affecting the property’s market price.
To calculate the fair market value, appraisers will rely a good deal on “comps,” or recent sales of nearby comparative properties. But valuation for commercial properties can be tricky, since there may be relatively few truly comparable sales of similar properties nearby.
Also, FMV can be subject to wide swings in investor sentiment – as property owners across the country learned in the last decade.
Actual Cash Value
This approach to underwriting attempts to calculate what it would take to replace a property and its fixtures – and then subtract an amount from that value for depreciation. For example, if a property includes a seven-year-old refrigerator that is depreciable over ten years, the insurance company may only value the refrigerator at about 30 percent of its replacement value. If you are insuring a 13 year-old rental house that is depreciable over 27.5 years, the insurance company may only be willing to pay half of the home’s replacement value.
This amount is grossly inadequate, in practice, for most of small business owners, who don’t maintain the kind of sinking funds this kind of coverage requires. After all, if your business relies on a working refrigerator and you lost it in a disaster, you lost a whole refrigerator – not just 30 percent of one.
Replacement cost underwriting attempts to estimate what it would cost to reconstruct the property on site, using comparable or equivalent construction methods and materials, where possible. This can be a very different figure from market value because buyers will also deduct for age and depreciation. Some industry experts also believe that replacement cost provides a useful cap on figuring reimbursements and insulates the risk pool from the distorting effects of appraisal fraud: Commercial property buyers won’t pay more for a property than it would cost to build the same thing next door!
Location is particularly important for commercial properties. Most experts recommend using replacement cost as a basis for calculating needed insurance coverage on commercial properties.
Most insurance agents have access to programs that help streamline estimating the cost of rebuilding common, basic structures.
Flood Insurance is Separate
Remember, standard commercial insurance policies don’t cover flood damage. To protect yourself against the financially devastating effects of flooding, you will need to secure separate flood insurance, both on the building itself and any contents in it you may own.
Some situations call for a more specific approach. If you own a historic or antique building, for example, you probably have some unique concerns that a typical warehouse owner around the corner may not have. For example:
- Rebuilding with prefab or other low-cost building techniques may not be warranted – especially if your business derives significant value from the unique character of an older building.
- Rebuilding may require materials and artisan workmanship no longer readily available.
- Your old structure may have been built before construction and wiring standards were modernized. This is particularly true if you are in earthquake-prone areas. Rebuilding may require additional expenses to bring the structure up to code.
- You may have greater business interruption costs than other comparable businesses because it takes that much longer to rebuild.
These cases call for a much more detailed and specific approach than simply calculating costs per-square-foot and adding some coverage for contents. A good insurance agent can help walk you through the issues involved in appraising these kinds of structures and estimating rebuilding costs. You may need to hire an outside appraiser with experience in certain specific construction techniques. At the end of the day, insuring antique, historic or specially-built or designed buildings is a team effort between yourself, your insurance agent and the insurance carrier.
Replacement Cost is available in most cases and unless you don’t intend to rebuild, this is the best option, since it will pay for the entire cost replacement your building without consideration for depreciation. When insuring for replacement cost, most policies require that you insure to 100% of what it would cost to replace your building. Insuring for 90% of actual building replacement cost would result in a co-insurance penalty of 10%. This means that if you had a partial loss, you would only get 90% coverage due to the co-insurance penalty found in policies with this clause. This is why it is so important to work with your agent and the insurance company appraiser if an appraiser has been assigned to value your building. Your building is your investment, and protecting your investment is a wise financial decision.
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