The impetus of this article is simple – we are asked multiple times a day by well-intentioned investors to improperly insure investment units for ‘Actual Cash Value’ (ACV) coverage instead of ‘Replacement Cost’ (RCT) coverage for the simple reason that there is a fundamental misunderstanding between the concepts of Actual Cash Value, Replacement Cost, and the seldom-used term “Agreed Value”.  Due to this misunderstanding, combined with the fact that investors are always looking at the cost of insurance and how it affects cash flow, most investors unknowingly assume that the terms ‘actual cash value’ and ‘agreed value’ mean the same thing.

THEY DON’T.

Is The Property Paid-Off or Does it have a Mortgage?

Let’s start from the beginning before we delve into defining the three types of claims coverages mentioned above.  To begin, if you have a mortgage on the property to be insured, there is a 99.9999% chance that it includes an often-ignored ‘insurance clause’, usually in boilerplate language, that states that hazard insurance is to be in-force at all times during the course of the loan term and that if insurance is not in place or if does not meet the lender’s basic requirements for insurance, they (the lender) have the right to ‘force-place’ insurance (at a MUCH higher premium) and add that cost to the payoff balance of the loan itself.  Yes, it’s in your mortgage documentation even if you have never read it and, as the cliché goes, “ignorance is no excuse.”

Generally, it is written in a manner such as the example below.

“For the entire term of the loan, hazard insurance for the named property with special form coverage must be obtained and in-force at all times in an amount equal to the replacement cost of the property, as determined by the insurance company, from an insurance company with a rating of “B+” or better by the A.M. Best Rating Guide, with “XYZ Mortgage” as the mortgagee on all policies, with no more than a 1% deductible.”

 The language itself may vary some, but that is a good example of what your insurance clause usually states.  If you purchase insurance with ‘actual cash value’ coverage (which is almost never a good idea in the first place) you are in immediately default of this insurance clause and the mortgagee may, as is its legal right under the terms of the mortgage, force-place coverage to protect its interest in the property and charge the extremely high premium directly to you.

However, if you do not have a mortgage on the property and it is paid in full, you are free to self-insure and/or purchase actual cash value coverage if you choose to do so; but you really need to understand just exactly what that coverage is to make certain that you don’t lose a dollar later just to save a nickel now.

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(A)   REPLACEMENT COST

Replacement Cost, often abbreviated as ‘RCT’ or ‘RCV’ is defined in insurance terms as “the cost to “replace the damaged property with materials of like kind and quality, without any deduction for depreciation.”  In other words, what it costs to repair the property after a loss or to rebuild the ‘sticks and bricks’ after a total loss without any concern about depreciated value.  This is the coverage that you want to have in place when an unexpected loss happens.

How Replacement Cost is Determined

The ‘replacement cost’ amount (sometimes referred to as the ‘reconstruction cost’) is not a number simply plucked from thin air by the insurance company; it is arrived at in a very logical manner.  You see, companies pay millions of dollars a year in licensing and usage fees to have access to information provided by a company known as Marshall Swift/Boeckh (known commonly as MS/B). This company, in the simplest terms, is a huge behemoth founded in 1930 that focuses on local building cost information and property valuation technology for the property and casualty insurance industry.  This company maintains accurate building costs data for every county and every zip code in the country in almost real-time fashion, updating their database information every 60 to 90 days.  When we obtain the physical information about your property (square footage, year built, construction type, finish-out grade, etc.) this data is input into their estimating system and based upon the physical characteristics of the property – as well as its geographic location – an estimated replacement cost value is determined.  This is the amount that insurance companies provide coverage for.  In addition, each company may have its own ‘safety buffer’ that it adds to whatever value is determined in order to make certain that enough coverage exists in the event of a total loss.  This means that you may provide the same information to three companies and yet get three different replacement costs coverage amounts back.  They will all be within the same general range of value and it does not mean that they are incorrect, it simply means that each company has its own ‘buffer’ amount that it adds to the estimated replacement value and this is often the reason for the differing amounts.

If you, as a property owner, provide inaccurate information about the property and the estimated replacement cost value is less than what is actually required in the event to rebuild or replace the property after a total loss, it is not the insurance company or agent that is at-fault for under-insuring the property due to the fact that quotes and valuations are based upon information provided by the investor/owner.

The 80% Co-Insurance Clause.  Going on with replacement cost coverage, virtually all property insurance policies written for replacement cost coverage also contain an embedded co-insurance clause requiring that the property be insured for at least 80% of its estimated replacement cost value in order to even qualify for replacement cost coverage.  The purpose of this is to make certain that owners are not intentionally under-insuring their property to save money yet expecting ‘full replacement cost coverage’ in the event of a covered loss.  In short, co-insurance is a penalty imposed on the insured property owner  by the insurance carrier for underinsuring the value of tangible property or business income. This penalty is based on a percentage stated within the policy (usually 80%) of the amount under reported.

As an example:

A property actually valued at $100,000 has an 80% coinsurance clause included in the policy but is only insured for $75,000. Since its insured value is less than 80% of its actual replacement cost (it’s only at 75%), when it suffers a covered loss (any loss), the insurance payout will be subject to the co-insurance penalty. For example: It suffers a $20,000 loss from water damage. If underinsured, you would only recover $75,000 ÷ (.80 × 100,000) × 20,000 = $18, 750 (less any deductible required by the policy).

In this example the underreporting/co-insurance penalty would be $1,250.

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(B)   ACTUAL CASH VALUE

Actual Cash Value (ACV) is defined in insurance terms simple as “Replacement Cost minus Depreciation”.  It does not mean that in the event of a loss that this is the amount of money you are going to receive.  Whereas replacement cost provides coverage to fully replace or repair any covered claim or loss, actual cash value does just the opposite.  It takes whatever the replacement cost is determined to be at the time of loss and then calculates and subtracts the estimated depreciation.  It does this for ALL covered claims that occur – not simply for a claim resulting in the total loss of the property.  A common question is “how much will the depreciation be?” and the answer is “No one knows until the claim actually happens.”  It’s literally a guessing game.

Depreciation is defined as:

“The decrease in the value of property over a period of time, usually as result of age, wear and tear from use, or economic obsolescence. Actual physical depreciation (wear and tear from use) is subtracted from the replacement cost of insured property in determining its actual cash value (ACV); courts in some jurisdictions have allowed insurers to deduct depreciation due to economic obsolescence as well.”

As the author of this article and an investor myself, I have to ask the question “Why even bother having insurance?”

As previously mentioned, almost all mortgage documents specifically require replacement cost coverage anyway and any policy with actual cash value coverage fails to meet the lender’s insurance clause and the lender then has the right to force-place coverage for a premium much higher than what you would pay by simply purchasing the right type of insurance in the first place.

In short, if you have ACV coverage on your property (unless there is a very specific reason that it was knowingly purchased), my opinion is that there is little or no point in even having property coverage at all.  If the issue it is purchased is simply to save money on the insurance premium, it’s faulty logic from the start due to the fact that you, as the insured, stand to lose much more financially in the event of a claim, any claim, than you would on the small amount of money spent in additinal premium due to purchasing replacement cost coverage in the first place.

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(C)   AGREED-VALUE

Agreed Value is seldom used when insuring real property though it is often confused with ‘Actual Cash Value’ above and this is why so many investors ask for ACV coverage; they think that they are actually asking for an ‘agreed value’ amount.  THEY ARE NOT.

Agreed Value (AV) is primarily used for tangible property or collector autos that are insured for a pre-determined amount by both the insured as well as the insurance company.  A common example is jewelry. If you had a watch that you purchased for $10,000 and you wanted to have it insured for its ‘agreed value’ under your homeowner’s policy, you would provide a copy of the purchase receipt (or recent appraisal) verifying this amount to the insurance company and they would add this watch to your policy in an ‘agreed’ amount of $10,000.  In the event that the watch was stolen or lost, the company would issue you a check for the $10,000 that had previously been agreed, even if the watch (for whatever reason) had actually dropped in value to only $8,000.  You would still get $10,000 since both parties had previously agreed on a flat $10,000 value for the item.

Conversely, if the watch had increased in value to $15,000, you would still only get $10,000 for the same reason just mentioned; both parties had previously agreed on a flat value of $10,000.  Unless you had the item re-appraised and the value increased on your policy, the prior valuation is what had been requested.

This does not generally apply to property insurance and ‘Agreed Value’ and ‘Actual Cash Value’ ARE NOT the same thing.  Agreed Value is seldom ever available for real property insurance.

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In summary, when requesting insurance coverage, it is important to understand that the only two policy choices for claim indemnification are either Replacement Cost coverage or Actual Cash Value – and that each one is decidedly different from the other.  In addition, your lender probably has very specific insurance requirements under the terms of the loan and in the event that your property has no loan and you are requesting actual cash value coverage, you need to ensure that you are doing so for the right reasons and that you fully understand the financial risk that you are actually taking.

Like I or not, it’s happening.  Property and casualty insurance rates are on the rise for the entire nation and they will continue to increase over the coming years.  For investors, this may mean diminished cash flow, increased exposure to loss (explained below) and a potential need to look for new insurance coverage. While no one likes paying insurance premiums, consumers have generally become accustomed to years of relatively-low and stable premium prices and any change is automatically viewed as extreme and unnecessary. However, this is not really accurate.  In addition to raising rates, many insurance companies will also be making other changes.  For example, those companies that have experienced large financial losses in claims for commercial and investment property and that want to begin backing out of insuring these types of risks and lessening their overall exposure to loss in these areas will begin non-renewing policies or raising the renewal premiums so high that they will, in effect, force the customer to find coverage elsewhere.  There will be changes within the policies themselves as well, with many ‘value added’ coverages that were not in the original policy but which have since been included in recent years as an additional enticement for purchasing them (such as foundation coverage) being removed from these same policies at renewal.  This means not only higher premiums but also less coverage.

The reason for these across-the-board premium increases is simple; it’s not directly related to ‘greedy insurance companies’ trying to make more money as many people would first think, but rather to the BILLIONS of dollars in claim losses that these companies have paid out over the past ten years as opposed to the amount of income generated from the premiums charged to their customers.  Despite the assumption that all insurance companies are flush with cash, the fact is that many insurance companies have had to pay more than they have made and some have even become insolvent and gone out of business.  Natural catastrophes such as Hurricane Ike, Hurricane Rita, Hurricane Katrina, Superstorm Sandy, the numerous fires and hailstorms in Texas, tornadoes throughout the Midwest, and numerous other disasters – combined with the regular day-to-day no- catastrophic claims – have taken their toll over the past decade and the insurance industry is being forced by sheer necessity to reevaluate pricing, coverage options, and even the types of risks or business they wish to insure.

Yes folks – many changes are ahead.

Add to this that the REINSURANCE rates that these insurance companies themselves pay have increased drastically as well.  It’s a little-known fact that insurance companies themselves purchase insurance (called re-insurance) to help cover losses and reduce their financial risks.  The reinsurance market is an entire behind-the-scenes industry unto itself and just like the premiums charged by insurance companies to their customers are increasing, so are the reinsurance rates that these companies themselves have to pay.  Some have increased by 150% or more – which means hundreds of millions of dollars in new expenses that did not exist a year ago.  Most of that expense get the rates that passed onto you and me (yes, I pay for insurance too!)

Many people want to know how insurance companies determine what rates will be charged – but there is no easy answer.  The insurance industry runs on statistics and mounds and mounds of actuarial data and it is often slices and diced a hundred different ways and each company has its own way of viewing risk. As a general rule, premiums are adjusted (raised or lowered) depending on several factors, including the type of risk and the past claims history that category of risk has experienced (i.e. Commercial Lessor’s Risk, dwelling policies, etc.), the geographic area that the risk is located in (down to the zip code or County level), how badly the company wants (or doesn’t want) to write a particular line of business in a particular area, and the individual characteristics of the insured (insurance score, claims history, and so on).  The amount of the premium change varies tremendously and it is not the same for all risks in all areas.

In summary, be forewarned that like most things in today’s world, insurance rates too are on the rise and they will continue to rise for the next 24 to 36 months before leveling out.  There is no longer such a thing as ‘good cheap insurance’ (an oxymoron itself) and if a premium is low compared to other companies, there is a reason – and it is in your best interest to find out what that reason is.  Is an important coverage being excluded or removed from the policy? Is the property quoted and insured correctly? Is the company financially stable?  You should ask questions before it’s too late and you find yourself in an unexpected situation with little or no coverage despite the fact that you were paying a premium.

While most property owners are familiar with typical exposures such as bodily injury, invasion, or privacy, and wrongful eviction (which themselves are not even covered in most landlord dwelling policies because they are ‘personal’ injury issues), this is one of the more unusual and interesting liability issues that we at InsuranceForInvestors.com have seen in a while and we thought it was worth sharing just to prove the point that any property owner can be sued for virtually any perceived wrong. You don’t have to be guilty to be accused - but you must still pay legal costs to defend your innocence…

 Read the Actual Story Below from CBS New York:

TOMS RIVER, N.J. (CBS New York) – Nighttime is fright time for a Toms River couple who claim the house they rented is haunted.

Jose Chinchilla and his fiancée Michele Callan say they hear eerie noises, that lights flicker, doors slam and a spectral presence tugs on their bed sheets.  The couple even called in investigators with the Shore Paranormal Research Society. The group classified the activity as “paranormal” but that it did not indicate a haunting, according to their website.

Chinchilla and Callan are suing the landlord for their $2,250 security deposit claiming the paranormal activity forced them out of the home only a week after moving in. However, the landlord believes the couple was actually spooked by the $1,500 a month rental fee and made up the ghost story to get out of their lease. The landlord has filed a counter suit against the couple. A hearing is expected at the end of this month.

Read Original Story

The same holds true with insurance. We have many companies that we work with and in order to put together accurate quotes, we need certain information required by the various insurance carriers – both about the property itself as well as regarding the mortgagee and certain personal information for the named insured(s).  With this in mind, we also have specific property information forms that we use to capture all of this information at one time.  If this information is not provided and/or if the parties simply refuse to supply the information requested, we are not in a position to spend hours making numerous phone calls and repeatedly asking for this necessary data.

The danger with providing quotes with only minimal information is that they aren’t accurate and they will most likely change (increase) in premium once the order to bind the policy has been given and reports are pulled by the carrier and accurate data finally obtained.

In order to develop the amount of insurance needed to adequately protect the property against loss, known as the reconstruction or replacement cost, we must first need to know the physical characteristics of the property such as the square footage, year constructed, number of bathrooms, construction grade, and so on.

As addressed in another question, the reconstruction or replacement cost value is not a number simply chosen at random. Most companies use the Marshall & Swift/Boeckh (MSB for short) data service to arrive at this value. MSB is a large global company which tracks the labor and material costs for every zip code in every county in the United States.  Insurance companies pay millions of dollars each year to utilize the MSB service and when performing quotes, agents are required to input the various construction data about the subject property such as square footage, number of baths, exterior construction, construction grade, and so on. This information is then used to calculate cost per square foot and total reconstruction value for the insured property.

The Surplus Lines insurance market (sometimes referred to as the non-standard market) exists to provide insurance to clients with risks that are not allowable in the ‘standard’ market.  These companies, most of which are “A-Rated” or better, are required to charge state tax and the carriers also charge policy fees. Some of the reasons a policy may need to be written in this non-standard market include:

• The named insured has experienced a foreclosure or bankruptcy within the past 5 years

• There are an excessive number of claims on the property

• The property itself exceeds the carriers underwriting guidelines in terms of construction characteristics, age, or maintenance conditions

Unfortunately, any checks sent from this account for reimbursement will only be made out to the person whose name is actually on the account (the seller).  This means that the seller will in turn have to cash this check and then send these funds back to the new buyer.  This may have to be done each year.  This is another inherent difficulty specific to subject-to and wrap-around mortgages.

NO. Only the Named Insured (Policy Owner) has the legal authority to make any modifications to the insurance policy, file claims, cancel the policy, or receive refunds.

Prior to cancellation for non-payment of premium, the named insured policy owner will receive several notices in order to make payment and keep the policy in force. If the policy does cancel, the named insured can contact us to make payment and we will have the policy reinstated ONE TIME if the carrier will allow it.  If the policy cancels again for the same reason, we will consider this to be a non-performing account and we will not have the policy reinstated.

Note: The reason that we will only reinstate the policy one time for a non-payment cancellation is due to the fact that, in our experience, many wrap-around mortgage transactions are not set up correctly by the parties and insurance is only obtained AFTER the actual closing – with the new property owner electing monthly insurance payments. Many of these policies get monthly notices of cancellations and require numerous reinstatements simply because the insured fails to pay the bill.