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The latest thinking on insurance to value — and why it matters to your business

Insurance Market Source regularly taps into its network of experts across the company to share their insights on key trends and developments in the markets in which you do business. Here Steve Heston, vice president of Loss Control Services at US-Reports, breaks down the ins and outs of insurance to value.

No matter the type of calculation, many brokers and agents have access to the same valuation tools that carriers use, and I strongly recommend taking advantage of them.

IMS: In a homeowners policy, what is the difference between market value and replacement cost?

Steve Heston: Brokers and agents may not realize that the core factor in homeowners insurance is not the market value of a property, but its replacement cost. There is often little correlation between the two; one is the price of selling the property, the other the cost of rebuilding the property if it were destroyed.

One of the key differences is that market value includes the value of the land itself, whereas replacement cost does not. For example, the land itself would not be destroyed in a fire.

Market value is also driven by local market conditions. Is real estate selling well? Is the market upside down? During the housing market slump a few years ago, we saw many cases in California, Nevada and Arizona where the replacement cost of the home exceeded the property’s market value. But the converse can also be true in overinflated markets, when home values are much higher than replacement costs.

IMS: What is the difference between replacement cost and actual cash value?

SH: The two most common ways insurance value can be determined are (1) purely on replacement cost and (2) on actual cash value, which incorporates a structure’s depreciated value.

Cash value comes into play particularly in homes built before 1930, when you often find unique finishings such as plaster walls, ornate woodwork or marble floors. Many of these interior features involved a level of craftsmanship, detail and cost that we frankly don’t see as often today. In these cases, it could get very expensive to replace everything in the house under a replacement cost policy.

For example, a solid-stone dwelling built around 1900, with 12- to 14-inch exterior stone walls is likely a candidate for cash value. The cost of replacing the structure in like-kind would simply not be cost-effective. On the other hand, cash value may not make sense for a newer construction home that hasn’t depreciated as much.

The benefit of a cash value policy is that it makes insurance coverage more cost effective for older homes. The cash value is essentially determined by the effective age of the structure, accounting for upgrades and updates. So if a house was built in 1910, with no upgrades, the depreciation will be quite significant. However, if the house has been gutted or re-roofed, for example, you might actually have an effective age closer to a “30-year-old” house in cash-value terms.

IMS: What are the various factors that determine costs?

SH: Evaluating the replacement cost requires accounting for all the factors involved, from demolishing the site, debris removal, removing damages, preparing new plans, acquiring permits and reconstructing the dwelling.

Location is one of the key factors that can impact an evaluation. Imagine a house in the heart of Beverly Hills versus a far-out suburb of Milwaukee. Even if the structures were identical, the costs of the materials and labor (and the costs of transporting them) will be widely different.

Site conditions are also important. For instance, a house may have originally been built on vacant land, but perhaps is now surrounded by other homes, driveways, shops or parks. This could make logistics more challenging, as you would need to find a place to store materials (perhaps requiring more lots or renting secondary storage areas for materials). Similarly, constructing a house on a steep hill or a beachfront can present unique challenges that affect costs.

IMS: What drives the cost up or down from year to year?

SH: Costs of most relevant materials are updated on a quarterly basis. We often see the biggest changes, however, following natural disasters. For example, after Hurricane Katrina high construction activity in affected areas drove up the cost of construction materials around the country.

IMS: What is the best advice you can provide brokers and agents regarding insurance to value?

SH: Brokers and agents don’t need to become line-by-line experts on insurance-to-value calculations, but they should be knowledgeable and comfortable enough with the valuation to properly explain it to clients.

For example, I’ve often seen replacement costs that are less than $100 per square foot. I don’t think I’ve met a reputable construction firm that could build a house for that amount. So to some extent, it is the broker’s responsibility to be wary of undervaluing.

When evaluating replacement costs, it is also important to account for the type of evaluation on the property, to ensure a new inspection is comparable to the old one. For instance, the original carrier may have inspected the structure based solely on its exterior, relying on default information for anything inside. If a new inspector does an interior/exterior valuation, he or she will look at things like the actual makeup of the kitchen and bathrooms (which can sway the total up to $100,000 or more).

No matter the type of calculation, many brokers and agents have access to the same valuation tools that carriers use, and I strongly recommend taking advantage of them. There is no harm in double checking and asking questions — it’s in the best interest of your clients!

IMS: How can brokers and agents avoid surprising their clients with the final evaluation?

SH: I believe transparency is key. You can often build trust with clients by looking at the valuation and explaining which elements of the property are driving costs up. In some cases, it may help to diffuse any surprises upfront by explaining why you suspect the home might be undervalued. After all, it is in no one’s interest to underinsure a home.

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