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?

  1. $888,889
  2. $3,111,112
  3. $3,200,000
  4. $3,888,889
  5. $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:

  1. How much was insured at the time of the loss, and
  2. 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