What's the deal with Replacement Value?

Question

I was just doing some due dilligence on a proprety and I spoke to my Insurance Company (USAA), and had a mild heart attack when they told me how much it would be to insure. 1st I ran it online and it came to be ~$6k/yr. I called because I swore I did something wrong, but the most she could do is halve that number. That's still $250/mo with a 10% deductible!

I digress, a little about the house: It was built at the end of the 1800s. It has been uninhabited for at least the last 5 years, probably 10. It sits in a nice neighborhood, but the houses are going for only $250k (they are all old and have been rehabbed in the last 10 years).

She quoted me that replacement value was $630k! How the hell did she come by that number? The City has it assessed at less than $50k. She mentioned that they would have to source materials identical to what is there now. Well if the house burns down.. I dont want that old *** house with knob and tube, plaster walls, and single pane windows... I want modern building practices. I'd take a $200k check and I would still say thank you.

I tried saying to her... well I wont replace it with a $630k home. I wouldnt be totally sure I would rebuild there.

How do I get this insurance down to a reasonable price?

Derek Lacy · Answer

@Steve BabiakAbsolutely, co-insurance is a bit built into my explanation, as in the results end up being the same. But for all those concerned a HUGE gotcha in a property policy is co-insurance, which is an under insurance penalty. In reality the scenario I gave above would be both depreciation and co-insurance penalties applied to get that lower amount, but I kept it simple.Remember underwriters wrote the insurance policy, so the under insurance penalty is based of a valuation that is in the sole discretion of the underwriter. Not your agent, not your realtor, not your contractor, not your property manager, the underwriter. Basically co-insurance is if you insure under a certain threshold, commonly 80% of their calculated value, but can be up to 125% depending on coverage form, you then become a co-insurer on the property. To use the 50k/200k example above, let's use a 1k deductible and 80% coinsurance. Lets again assume 50k in damage.Step one depreciate, so that 50k is now 25k (most, but not all, insurers max out depreciation at 50%).Step two determine underinsurance, you should have insured at $100k (remember depreciation maxes out at 50%, meaning 200k at 50% depreciation is $100k). Now bottom dollar you should have insured at $80k (80% of value). $50/$80 is 0.625. So apply that factor to the depreciated claim amount of $25k. That gives us $15,625. Now take out the $1,000 deductible, your at $14,625. Which is right there on my off the cuff somewhere between $12,500 and $20k payout. This is the most correct, but I feel if most people just view the number they insure the house for $50k in this example, they need to look at that number as to mean if 50% of the house burns down, you will get half that amount, so $25k payout. If they look at it that way, they will get a better idea.Though again, if you're buying historic homes, that are not in historic districts, and are okay if it is replaced with less than historic items, go functional value, that get's rid of coinsurance complete. At minimum do agreed value to again delete coinsurance. Don't believe State Farm agents when they say our policies don't have coinsurance. They can legally say that because they call it an "Insurance to Value" clause, but when you put the standard coinsurance clause next to their "Insurance to Value" clause, you end up with the same concept different name. Thanks for the call out, it's storming here in Indy, the kids and wife are resting, so a perfect time to BP.

Derek Lacy · Answer

There are no such things as a market value policy. I have been told many times, by clients outside the industry that there is, I have not seen that policy ever presented. They may have used a term "Actual Cash Value" which is not market value. Actual Cash Value is defined as replacement cost minus depreciation. So in your scenario @Bill Bodziak you just told the insurer you are cool with 75% depreciation on all claims. Meaning $40,000 fire occurs (remember a contractor can only speak in new building value, replacement cost) will pay out about $10,000 before application of deductible. So to get to the OP, @Dave G. G.'s question. Imagine two identical houses built in 1950 on opposite sides of town. In the 65 years following, one house is in the neighborhood with great schools, great city services, etc. The other house is in the neighborhood that is consistently on the 11 O Clock news. Which house will cost more replace? They should be identical as they are identical houses. Which has the higher market value? Well the better neighborhood.So how does an insurer level that issue. Well you have to not care about market value, again, I have seen no insurance policy ever issued on a "market value" policy. If you only want to replace the function of a home if it were to be hit by a claim, you may want to look into functional value (replaces the function of the home, but not necessarily the home). Dave, I am literally sitting 1 block off of Mass Ave in Indianapolis enjoying a coffee and know our market very well, many investors on this board will even refer me. Let me know if I can help with your confusion. Though our independent agency (2nd largest privately held agency in the US per Insurance Journal) is licensed in all 50 states, this is really easy to do in my own back yard. Thanks!

Paul J. · Answer

Dave although USAA is one of the better Insurance companies they do have high premiums. Call a Independent Insurance who represents many Insurance companies because he is Independent. If you are near a farm community you may want to look into Farm Bureau insurance. Paul

Sam K. · Answer

Ditto. Acv is the way to go in this case. Recently had a fire claim on an ACV policy. Was positively surprised to find out that the depreciation deduction often talked about on cash policies applies to materials only. At least here in WI they could not depreciate the labor amounts. In my situation the check cut at the end allowed me to fix the place up and was enough to recover even most of my large deductable. Not surprising when you think about labor costs vs rental grade material costs.

Bill Bodziak · Answer

Very helpful info @Derek Lacy Functional Replacement Value or a higher ACV value seems like it may be the right way to go. Time to go insurance shopping......again :( Thank You!

Steve Babiak · Answer

@Derek Lacy omitted the concept of co-insurance - that can be another gotcha in the replacement amount you receive in a claim. On those older buildings, you will want to look into a "law and ordinance" rider so that you get latest code compliance covered if you re-build. Because if / when you re-build, you will have to meet the latest code.

Derek Lacy · Answer

@Dave G.Or just do functional replacement value. You want walls, you probably don't care if they are plaster replaced, the cheapest method that get's you walls is probably what you want. In that case you are good. Now I'm an independent agent, so we have insurers that offer that, but a USAA or other big name brands will not. That's not to say we don't represent name brands (travelers, hartford, liberty mutual, etc) but they just don't offer that.

Dave G. · Answer

@Derek LacyThat was a great example. I suppose that insuring for the 98% of occurences is exactly what Insurance is made for. This is really making me reconsider by buying area. When I spoke to someone giving me a quote, she asked if the walls were plaster, because those are expensive. Theoretically, could I decrease the replacement value of $630k if I ripped out all the plaster and replaced it with drywall before getting the insurance.

Derek Lacy · Answer

@Bill BodziakI know, your agent knows and more importantly the underwriter on the policy and the adjuster that will adjust the claim will know, that most people do not read their policy, and even if they do, they do not understand it. Caveat Emptor applies in the insurance purchase world, meaning let the buyer beware, which is good and bad. Good, you can ask for anything, someone will try to translate as close as possible and you can get that policy, Bad, you have a policy that will only pay out what it says it will pay out, you didn't read all the details nor understand all of the details. Actual Cash Value is what you probably chose. This means two things. One the value of the property is replacement cost minus depreciation. If you had one place tell you replacement would be $200k, you then insure for $50 on ACV. You just declared how much you depreciate the property as a whole. Since you just said that the property as a whole was only worth $50k. So the claim payout follows the same formula, you are paid out replacement cost minus depreciation. Luckily claims adjusters don't always take that depreciation level literally and will give some wiggle room, but don't expect to receive full damages either. All of you are correct, if the place burns all the way down, who cares, take the money and reinvest. What happens if it partially burns down? By the way total losses only account for 2% of claims paid, it makes me wonder why real estate investors always prepare for the 2% occurrence and not the 98% occurrence. So that property that was determined to be replacement cost of $200k (what replacement cost tells us is what a qualified licensed contractor would charge to replace the full house today), is insured for $50k. The fire does $50k of damage (acording to the contractor). That means only 25% of the home burnt, so you should only expect about 25% of your policy to pay out. So about $12,500 if I'm doing my math right. With the fudge factor I would imagine the adjuster would use, you would actually be paid about $20k for the $50k of damage.So now you have a partially burnt property, $20k in cash, $40k in fixes (once you cut all the corners you can).Insurance is something you get EXACTLY what you pay for, for good or bad.

Brian Tremaine · Answer

If it is 3000 square ft then I'd be paying about $2100/year in San Jose CA using Farmers.