Replacement Cost Reimbursement
Course: Insurance Planning
Lesson 6: Commercial Property and Liability Insurance
Student Question:
Hi,
The way I understand the example below is that since the cost, current value and depreciation are not relevant, it seemed to me that the building is only insured for 77.77% of its replacement value ($14,000,000/$18,000,000). This would lead to the payout from insurance only being $3,111,111. Any help with where I am wrong is appreciated.
Peter purchased an apartment building for $15,000,000 five years ago. The apartments were appraised a few months ago for $19,500,000 (market value). The building has depreciated by $2,250,000. Peter has the apartment building insured for $14,000,000 on a replacement cost basis. The replacement cost is currently estimated at $18,000,000. The insurer requires 80% coverage for full replacement cost coverage. Recently, a fire damaged the top floor of the building and water damage to the next two floors. It will cost $4,000,000 to restore the building to its former condition. How much of the $4,000,000 replacement cost will the insurer pay?
Thank you.
Instructor Response:
Hi
These can certainly be confusing! You’re very close, but the reason your answer is off is that coinsurance uses 80% of the replacement cost—not 100%—to determine whether the building is adequately insured.
So where you want to start is to determine — What is the required amount of coverage needed?
In this question, we state the insurer requires 80% coverage. So, we take 80% of the replacement cost (80% of $18m) which is $14.4.
This means Peter needs to have $14.4 million of coverage.
So now, knowing Peter has only $14 million, we know he is underinsured and we now must apply the coinsurance formula. We take the amount of coverage he has ($14m) and divide that by the amount required (14.4). 14/14.4 = 0.972222.
We then multiply .97222 by the loss, which was $4m. So $4,000,000 times 0.972222 gives us our correct answer of $3,888,889.
Does that help clarify for you? Please let me know!
