(June 2019)
Properties insured under the Insurance Services Office (ISO) Commercial Property Coverage Forms are valued at either actual cash value or replacement cost value. Property not properly insured to value is subject to a significant coinsurance penalty if a loss occurs. However, certain buildings should not be insured for their replacement cost or even their actual cash value because doing so could actually create a significant moral hazard as well as generate much higher premiums than necessary.
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Examples: Scenario 1: Rex’s Shoes built a large, six-story solid masonry building in the early 1900’s to house its manufacturing operations. Changes in technology in recent years changed the shoe manufacturing process and the new and improved equipment is much more streamlined and compact. Even though Rex’s business is booming, and operations are at full capacity, it uses only three of the six stories. Rex uses the top three stories for dead storage. If the building was destroyed, Rex’s Shoes would not replace it with one of the same size because a much smaller building would easily accommodate its present operations. Scenario 2: Petal Pushers purchases a unit in a downtown row building. The unit is four stories high and Petal Pushers occupies it as a florist and gift shop. The retail store operation is on the first floor and the second floor houses the offices, employee break room, locker room, and other facilities. The top two floors are used as an apartment. The building is poured concrete construction with ornate, decorative features on the wall that faces the street. The actual cost to replace this unit with one that has similar features is well over $2,000,000. The high cost is due to the type of construction and the craftsmanship needed to match the ornate features. However, Petal Pushers would not replace it with the same type of construction and decorative details. It would rather replace it with a less expensive structure constructed of solid brick. Scenario 3: Thriving Restaurant has occupied its rented building for over 60 years. It purchased the contents from the prior tenants and, while beautiful and worth over $500,000 at replacement cost, their clientele is not impressed with pricey regalia. Thriving estimates that it could replace everything for only $100,000. |
CP 04 38–Functional Building Valuation endorsement is available to address these and similar needs for building owners. CP 04 39–Functional Personal Property Valuation Other Than Stock is available to address personal property needs.
The post-loss ordinance and law changes introduced in the 09 17 edition
of the CP 04 05–Ordinance or Law Coverage and other modifications to that
coverage are the only changes made in the 09 17 edition of the CP 04 38.
Discussions regarding those changes are addressed in the CP 04 05–Ordinance or
Law Coverage article.
Related Article: CP 04 05–Ordinance or Law Coverage
CP 04 38 and CP 04 39 can be added to a CP 00 10–Building and Personal Property Coverage Form or CP 00 17–Condominium Association Coverage Form. CP 04 39 can also be added to CP 00 18–Condominium Commercial Unit-owners Coverage Form. Each has its own schedule. In order for the valuation these forms provide to apply, the insured must:
In addition, CP 04 39 must describe the specific type of personal property covered.
The language in each endorsement opens by stating that the coinsurance additional condition does not apply. This is important because this eliminates the potential for a coinsurance penalty.
This endorsement modifies the Valuation and Other Insurance Condition and adds Ordinance or Law Coverages.
In addition, it modifies the Other Insurance Condition and includes a modified version of Ordinance or Law Coverage.
The functional building valuation amendment replaces only paragraphs a. and b. in the Valuation condition. The remaining paragraphs continue to apply. It also adds two new valuation provisions.
If the insured contracts to repair or replace the damaged building for the same occupancy and use within 180 days after the covered loss or damage, the insurance company pays the least of the following:
If the insured does not repair or replace as outlined in Option 1 above, the insurance company pays the least of the following:
The endorsement defines market value as the price the insured might have expected to receive for the property in a fair market before the loss occurred. The problem here is that most fair market value includes the value of both the land and the structure. Negotiation may be required to determine the portion of the fair market value that applies to the land versus the part that applies to the structure.
While this paragraph appears in this endorsement, it does not state that it replaces the Other Insurance Condition in the Common Property Conditions.
Related Article: CP 00 90–Common Property Conditions Form Analysis
The wording refers to "this Functional Building Valuation insurance" instead of simply referring to just property coverage. This means that the only other insurance coverage subject to any proportional sharing is another Functional Building Valuation endorsement. In cases where coverage is not the same, the insurance this endorsement provides is excess.
The coverage provided is nearly identical to that provided by CP 04 05–Ordinance or Law Coverage. Related Article: CP 04 05–Ordinance or Law Coverage
One significant difference in this edition is that there are no provisions for separate limits for Coverage B–Demolition Cost Coverage and Coverage C–Increased Cost of Construction Coverage. This means the building limit must include the cost to rebuild the building, the cost to demolish undamaged portions of the building, and the cost to rebuild the property, subject to current ordinance or laws.
This section does not have separate Loss Payment provisions for this coverage because it is considered part of the Functional Building Valuation. This endorsement includes an example of Proportionate Loss Payment for Ordinance or Law Coverage Losses similar to the explanation in CP 04 05.
This endorsement introduces two new valuation provisions.
If the insured contracts to repair or replace the damaged personal property for the same occupancy and use within 180 days after the covered loss or damage, the insurance company pays the least of the following:
If the insured does not repair or replace as outlined in Option 1 above, the insurance company pays the least of the following:
The endorsement defines market value as the price the insured might expect to receive for the property in a fair market before the loss occurred.
Functional Valuation coverage recognizes that there are differences between old and new buildings and also old and new personal property. It is important to spend the amount of time necessary to evaluate and document those differences and the reasons for choosing functional valuation so that the final value is credible. Thorough and thoughtful evaluations help both the agent and the insurance company identify any possible moral or morale hazards and the insured's overall thought process.
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Example: The owner of Olde Tyme Pretzels comes to you for insurance. Old Tyme's building is one of the oldest in the city and has extensive trim and numerous other decorative features. You develop the following list of considerations to help determine a functional valuation:
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Functional Valuation offers workable alternatives to the problems related to repairing and replacing older, ornate, or very large buildings and personal property or buildings that have unique features. CP 04 38–Functional Building Valuation and CP 04 39–Functional Personal Property Valuation Other Than Stock reduce or eliminate problems that involve valuation, coinsurance considerations, and moral or morale hazards. When proposing using these endorsements to an insured, a thorough explanation along with examples of possible claims settlements should be provided so that a settlement offer, especially for a partial loss, does not come as a surprise.