Value Damaged Property Correctly

Introduction

When property is damaged, "What was it worth?" has more than one honest answer. A six-year-old oven has a price for a new replacement, a lower value as a used oven, and a small leftover value as scrap. The policy decides which of these values measures the loss.

This lesson teaches you to calculate and compare those values. It then shows why the value of the loss is only the first step toward the insurer's payment.

What you will be able to do

• Calculate replacement cost and actual cash value from given figures, and explain why they differ.
• Tell market value apart from the cost to rebuild.
• Apply an agreed value clause and a stated amount clause to a total loss, and explain when they give different results.
• Explain salvage value and decide whether it changes a payment, using the policy's settlement terms.
• Explain indemnity and separate the value of a loss from the final payment.

Before you start

You should know what an insurance policy is for. That is covered in Why insurance works and what it can insure. You should also be able to tell whether a cause of loss is the kind a policy covers, as taught in Read a loss scenario: peril, hazard and cause.

A few words used throughout:

• The insurer is the insurance company. The insured is the person or business the policy protects.
• A covered loss is damage the policy agrees to pay for, such as damage from a cause of loss the policy includes.
• Valuation means deciding how many dollars the damaged property represents.

Every person, business, amount and policy clause in this lesson is fictional. Each example states the policy terms it uses. These are general property-insurance valuation ideas, not a Nevada formula. In a real claim, the actual policy wording controls.

Replacement cost: the price of new, similar property today

Replacement cost is what it would cost today to repair the property, or to replace it with new property of similar kind and quality.

Example: Sunrise Bakery's commercial oven is destroyed by a covered fire. The bakery bought the oven six years ago for $9,000. A new oven of similar kind and quality costs $12,000 today.

The replacement cost is $12,000.

Why $12,000 and not $9,000? Replacement cost asks what it costs now to get comparable property. The $9,000 purchase price describes a past transaction, not today's cost.

"Similar kind and quality" also sets an upper bound. If a deluxe oven with extra features costs $18,000, that does not become the replacement cost. Replacement cost means comparable property, not an upgrade.

Check: A tenant's water-damaged carpet was installed eight years ago for $3,200. Installing similar new carpet today costs $4,500. A premium carpet would cost $7,000 installed. What is the replacement cost?

Actual cash value (ACV): what the used property was worth, given its age and wear

Actual cash value, or ACV, is the value of the property in its used condition. It accounts for age and wear and tear.

The value lost to age and wear is called depreciation. A six-year-old oven has had six years of use, so it is worth less than a new one.

ACV can be measured in more than one way, and the policy defines its method. In this lesson, assume ACV = replacement cost − depreciation. Each example gives the depreciation percentage.

Worked example, continuing the oven. Assume 40% depreciation.

1. Start with today's replacement cost: $12,000.
2. Find the depreciation: 0.40 × $12,000 = $4,800.
3. Subtract it: $12,000 − $4,800 = $7,200 ACV.

You can check the result another way. If the oven lost 40% of its value, it kept 60%, and 0.60 × $12,000 = $7,200. Both paths agree.

The result also makes sense in size. Under this method, ACV can never be more than replacement cost, because depreciation is subtracted from replacement cost.

Change one fact. Suppose the oven were only two years old, with 15% depreciation. Replacement cost stays $12,000, because a new oven costs the same either way. ACV becomes 0.85 × $12,000 = $10,200. Less wear means less is subtracted, so ACV moves closer to replacement cost.

A tempting mistake is to apply the depreciation to the purchase price: 0.60 × $9,000 = $5,400. Under this lesson's method, depreciation is taken from today's replacement cost, not from what the bakery once paid.

Check: Return to the carpet, with replacement cost of $4,500. Assume 50% depreciation. What is its ACV? Which is larger, the replacement cost or the ACV, and why?

Market value: what a willing buyer would pay

Market value, also called fair market value, is the price a knowledgeable buyer would pay and a knowledgeable seller would accept, with neither under unusual pressure. In plain terms, it is what the property would sell for.

For a home, market value includes the land under the house, and it rises and falls with the real estate market. Replacement cost asks a different question: what would it cost to rebuild the house itself?

Example: Appraisers estimate that a house and its lot would sell for $425,000. A builder estimates $310,000 to rebuild the house with similar materials. A fire destroys the house, but the land is undamaged.

• The cost to rebuild the house is $310,000. That is its replacement cost.
• The $425,000 sale price includes the land, which the fire did not destroy, and reflects buyer demand in the area.

Change one fact. Suppose the local real estate market falls and the house and lot would now sell for only $290,000. Rebuilding still requires the same work and materials, so the $310,000 rebuild estimate does not drop just because sale prices did. Market value and replacement cost can differ in either direction.

A tempting mistake is to set the house's coverage at its sale price. A consumer guide from the national association of state insurance regulators says dwelling coverage should equal the full replacement cost of the home. It also notes that market value includes the land.

Check: A cabin and its lot would sell for $260,000. A contractor estimates $195,000 to rebuild the cabin with similar materials. Which figure measures the cost to rebuild the cabin? Why isn't the other figure that measure?

Agreed value and stated amount: two policy figures that settle differently

Some policies write a dollar figure into the policy itself. That is useful for property whose value is hard to pin down, such as a rare antique or a classic vehicle.

Two arrangements look alike but work differently:

• Agreed value: the insured and the insurer agree on the property's value when the policy is written. In this lesson, assume the fictional agreed value clause says that for a total loss, the insurer pays the agreed value.
• Stated amount: a figure written in the policy that acts as a ceiling. In this lesson, assume the fictional stated amount clause says that for a total loss, the insurer pays the stated amount or the ACV, whichever is less.

A total loss means the property is treated as completely lost, rather than repaired.

Worked example: A classic motorcycle is a total loss after a covered event. At the time of loss, the insurer's ACV for the motorcycle is $19,000.

• Policy with a $26,000 agreed value. The clause pays the agreed figure, so the payment is $26,000. The $19,000 ACV does not reduce it.
• Same motorcycle, $26,000 stated amount instead. Compare the two figures: $26,000 versus $19,000. The lower one is $19,000, so the payment is $19,000.

The written figure is the same in both policies, but the payments are different. The deciding difference is whether the figure is the payment (agreed value) or a ceiling compared with ACV (stated amount).

Change one fact. Suppose the stated amount is $15,000 and the ACV is still $19,000. The lower figure is now $15,000, so the payment is $15,000. In this case the ceiling, not the ACV, sets the result.

A tempting mistake is to assume a stated amount guarantees that amount. Under a lower-of clause, the stated amount guarantees only that the payment will not exceed it.

A necessary qualification: these labels are not used identically in every product. One insurer's description of agreed value says it pays the lower of the repair cost or the agreed value for a covered loss. That is why this lesson's examples state the clause and use total losses only. On a real policy, read the settlement wording.

Check: An antique cabinet is a total loss. A similar replacement costs $14,000, and depreciation is 35%. Find the ACV. Then find the payment (a) under a $10,000 stated amount clause and (b) under a $10,000 agreed value clause.

Salvage value: what the damaged property is still worth

Salvage value is value that can still be recovered after a loss. For example, a damaged item might be sold for parts or scrap.

Every value covered so far describes the property before the loss: what new similar property costs, what the used item was worth, or what a buyer would have paid. Salvage value is different, because it describes what remains after the loss.

Example: A recycler offers $600 for Sunrise Bakery's burned oven. That $600 is the salvage value. It is not the oven's ACV ($7,200) or its replacement cost ($12,000).

Knowing the salvage value does not, by itself, tell you to subtract it. The settlement terms decide. Compare two fictional clauses for the same oven, both paying ACV:

• Clause A: the insurer pays ACV and makes no salvage adjustment. Payment basis: $7,200. The $600 does not enter the calculation.
• Clause B: if the insured keeps the damaged property, the payment is reduced by its salvage value. The bakery keeps the oven, so the payment basis is $7,200 − $600 = $6,600.

A tempting mistake is to subtract salvage value whenever a problem mentions it. Subtract it only when the terms you are given say to.

Check: A print shop's damaged copier has an ACV of $5,000, and a recycler offers $250 for it. (a) The policy pays ACV and makes no salvage adjustment. What is the payment basis? (b) The policy instead reduces the payment by salvage value when the insured keeps the property, and the shop keeps the copier. What is the payment basis now?

Indemnity: back to where you were, not ahead

Indemnity is the principle that insurance should restore the insured to their financial position before the loss, and no better. The insured should not profit from a loss.

The reason matters. If people could come out ahead after a loss, some would have a reason to cause losses or to stop trying to prevent them.

Apply it to the oven. Before the fire, the bakery owned a six-year-old oven worth $7,200 under this lesson's ACV method. An ACV payment of $7,200 restores that position: the bakery is neither richer nor poorer.

Two arrangements from this lesson can pay more than the used property's value:

• Replacement cost coverage pays the cost of new, similar property with no deduction for depreciation. Under it, the bakery could end up with a new $12,000 oven in place of a used one.
• Agreed value (also described as a valued policy) pays the agreed figure even if the ACV is lower, as with the $26,000 motorcycle.

Each of these is a specific policy arrangement. Indemnity does not automatically switch a policy to replacement cost, and it does not turn an agreed figure into market value.

Indemnity also works as a ceiling, not a promise of full repayment. Deductibles and limits can leave part of a loss with the insured, as the next section shows.

Check: Under each payment below, is Sunrise Bakery ahead of, equal to, or behind its pre-fire position of a $7,200 used oven? (a) $7,200 ACV payment. (b) $12,000 replacement cost payment. (c) $7,200 ACV minus a $1,000 deductible, for a $6,200 payment.

The value of the loss is not yet the payment

Finding the right value answers only the first question. Think of the claim in two steps:

1. Value the loss using the policy's valuation method: replacement cost, ACV, agreed value, a stated amount comparison, and any required salvage adjustment.
2. Apply the policy's other terms to that value. Two of those terms: - A deductible is the part of a covered loss the insured pays before the insurer pays. - A limit is the most the policy will pay.

Both of these come before any of this matters: the loss must be covered in the first place.

Assume this fictional rule: subtract the deductible from the valued loss, then pay no more than the limit. Calculate deductibles, limits and coinsurance explains these terms in depth.

Worked example. The oven's valued loss is its $7,200 ACV, with no salvage adjustment. The policy has a $1,000 deductible and a $20,000 limit.

• After the deductible: $7,200 − $1,000 = $6,200.
• The limit is $20,000, and $6,200 is below it, so the insurer pays $6,200.
• The bakery keeps $1,000 of the loss.

Change one fact. Suppose the limit is $5,000 instead. After the deductible the figure is still $6,200, but the policy pays no more than $5,000. The insurer pays $5,000, and the bakery keeps $7,200 − $5,000 = $2,200.

The valuation did not change; only the payment did.

A tempting mistake is to give the valued loss ($7,200) as the payment. Read what the question asks for: the value of the loss, or what the insurer pays.

Check: A fictional policy values the oven at replacement cost ($12,000), with no depreciation deduction. It has a $1,000 deductible and a $10,000 limit, and uses the same rule as above. What does the insurer pay, and how much of the $12,000 does the bakery keep?

Practice on your own

Work each problem before opening the answer.

Problem 1. A covered fire destroys a landscaping company's four-year-old riding mower. The company paid $8,000 for it. A new mower of similar kind and quality costs $9,500 today. Assume 30% depreciation. A scrap dealer offers $400 for the wreck.

Under Policy A, the policy pays ACV, makes no salvage adjustment, and has a $500 deductible and a $15,000 limit. The insurer takes the wreck. Subtract the deductible, then apply the limit.

(a) Find the replacement cost and the ACV. (b) What does the insurer pay under Policy A? (c) What role does the $400 play? (d) Is the company ahead of, equal to, or behind its pre-fire position? (e) Policy B is the same as Policy A, including that the insurer takes the wreck, except that it pays replacement cost with no depreciation deduction. What does the insurer pay under Policy B?

Problem 2. A vintage neon sign is a total loss. The policy figure is $12,000.

(a) The insurer's ACV at the time of loss is $14,500. Find the payment under a stated amount clause (pays the lower of the stated amount and ACV) and under an agreed value clause (pays the agreed value). (b) Now suppose the ACV is $9,000 instead. Find both payments again. (c) Describe when the two clauses give the same payment.

Problem 3. Appraisers estimate a duplex and its lot would sell for $480,000. A builder estimates $365,000 to rebuild the duplex with similar materials. The owner bought the property ten years ago for $300,000. Label each figure as replacement cost, market value, or neither, and explain your choice.

What to remember

• Replacement cost is today's cost of new, similar property, not the original purchase price and not an upgrade.
• ACV is the used property's value after age and wear. In this lesson, ACV = replacement cost − depreciation. Take the depreciation from replacement cost, not from the purchase price.
• Market value is what a willing buyer would pay. For a home, it includes the land and can be higher or lower than the cost to rebuild.
• Agreed value pays the agreed figure for a total loss under the stated clause. A stated amount is a ceiling compared with ACV under a lower-of clause. Read the exact clause.
• Salvage value is what remains after the loss. Subtract it only when the settlement terms say to.
• Indemnity means no better than before the loss. Replacement cost and agreed value terms can pay more because they are specific arrangements. Deductibles and limits can leave part of the loss with the insured.
• First value the loss, then apply the policy's other terms. The valued loss and the payment are different answers.