Required Insurance Penalty and Reimbursement
Course: Insurance Planning
Lesson 6: Commercial Property and Liability Insurance
Student Question:
Hi Dan –
On this review page, the correct answer for Question 2 (below) indicates that insurance will pay only over 97% of replacement cost. However, it says in the chapter that as long as the property is insured for more than 80% of replacement cost, the policy will pay the full cost up to the policy limit. Here, the policy limit is $14MM, so I’m confused as to why the insurance will cover 97% instead of 100%.
Review Exercise:
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?
- $888,889
- $3,111,112
- $3,200,000
- $3,888,889
- $4,000,000
Thanks.
Jordan
Instructor Response:
Hey Jordan-
Good to hear from you. Hope you and your family are healthy and remain so.
The keys here are:
- How much was insured at the time of the loss, and
- The replacement cost.
The other information, such as depreciation, represents typical CFP Board distractors. So, here’s how we get there:
- 80% of the replacement cost is $14.4MM and current insurance in place is $14MM.
- We need to calculate the ratio of actual coverage to required coverage to determine how much of the $4MM loss is covered.
- We divide the amount of insurance in place by the minimum required insurance at 80%: $14MM/$14.4MM = 97.2%
- The $4MM loss will be covered at 97.2% for a payment of $3,888,889
- If there were a deductible (there is not), the deductible would have been subtracted from the $3,888,889
Hope that helps!
Dan
