WHEN REPLACEMENT INSURANCE DOESN’T PAY TO REPLACE YOUR BUILDING DAMAGE
by Rosemary A. Macero
A condominium’s worst nightmare is hazard or fire. Most unit owners do not worry about hazards or fire because the unit owners, like the trustees, think that they have purchased a Master Insurance Policy which includes “replacement cost coverage”. While a hazard loss is devastating to the Association and to the effected unit owners, most unit owners and trustees believe that based upon the expense of a “replacement cost coverage” insurance policy, rebuilding after a hazard or fire will not be problematic and sufficient funds will be provided by the insurance company, under the insurance policy, to complete this process.
Replacement cost coverage is a deceptively simple concept. Most unsuspecting owner / consumers and Associations understand, based upon the description of this type of hazard/fire insurance as “Replacement Cost”, that this type of hazard insurance coverage will provide enough insurance money to permit them to restore the fire damage and replace the building or structure to its former use. Unfortunately, replacement cost coverage in actuality does not, except in rare circumstances, provide sufficient funds for the owner/consumer or Association, to replace the hazard / fire damage without significant unit owner assessments to complete the work.
There are two basic types of hazard insurance available to fund the reconstruction of a hazard damaged building. The standard coverage permits the building owner to insure the value or cost of the building. In the event of hazard/fire damage, the insurance company is obligated by contract to pay the actual cash value of the loss up to and including the stated value on the policy. For example, if you purchase property with a purchase price of $500,000 at the time of purchase, you insured the property for the purchase price (the stated value) on the insurance policy of $500,000. In the event that the building is completely destroyed by a covered hazard1 identified by the insurance contract, the insurance company is obligated to pay a maximum of the actual cash value of the damage to the structure, but not more than the $500,000 insured by the policy.
In purchasing a replacement cost policy, the owner, by the name of the coverage, is lead to believe that if it sustains a $500,000 loss on property which has a $500,000 replacement cost policy, and if the building cost more than $500,000 to replace, the insurance company would pay the full replacement cost necessary to restore the building to its use. Obviously, as long as the owner is not replacing the building with a larger, more luxurious or materially different building, but is merely replacing or restoring the damaged parts of the building to their original size, shape and use, if the coverage is for “replacement cost”, why should the insurance company refuse to pay the cost to replace the damaged portions, regardless of the cost.
Why not? The replacement cost coverage is more expensive than the standard stated value coverage. The insurance companies market this coverage to owner/consumers and they explain that the cost for the coverage is more expensive because the policy pays for the cost to replace the damaged portion of the premises. But does it really pay the cost to replace.
The answer is unfortunately a resounding – NO. Little known is the fact that in most, if not all, replacement cost coverage policies, insurance companies have sought to limit the replacement value they will be contractually required to pay, by inserting in the replacement cost policy language that will permit the insurance company to exclude (read as reduce) from the replacement cost moneys, the cost of reconstruction which is related to “code compliance”. Code compliance cost are the cost that an owner will have to spend to reconstruct the damage, which costs are attributable to bringing the building into compliance with current building and sanitary and other codes or ordinances which are in existence at the time of the reconstruction. What this means is, the older the building, which you are insuring under a replacement cost policy, the more likely that the insurance company will use this code compliance “upgrade” exclusion to reduce the amounts it must pay to the owner under the replacement cost coverage. Taking the example from above, our replacement cost coverage is $500,000 for a building built in the early 1980s with no sprinkler system. At the time of the hazard, based upon the size of the building and its use, if built presently, the building would require a sprinkler system. To obtain both a building permit and certificate of occupancy after the reconstruction from the damage is complete, the owner will have to pay to have a sprinkler system installed. The owner is replacing the same building, on the same footprint, with similar kind and quality materials. If the building costs $500,000 to reconstruct and $50,000 of this cost is the cost of the sprinkler system, the insurance company will rely upon the “code compliance upgrade” exclusion to limit or reduce its payment of the replacement costs to $450,000. So in effect, although the owner has had to pay $500,000 to replace the damaged property so that it can be used and occupied as it had been prior to the incident, the insurer will deduct the cost of the sprinkler system from its payment under the policy.
Can the owner then just refuse to install the sprinkler system in the reconstructed building? No. If the owner omits the sprinkler system in our example, the local authorities or the State will refuse to issue a building permit or a certificate of occupancy for the building. So the owner is left with the option to reconstruct a building with his replacement cost money minus the cost of the sprinkler system, without the sprinkler system, after which time the building can not be occupied and therefore has no value. Or the owner is forced to pay from the owner’s own funds the cost of the sprinkler system without in order to use the building.
The code compliance upgrade exclusion is not limited to new buildings or new building systems. It can be applied to plumbing and electrical systems, in public buildings – handicap access, it can even be applied to earthquake standards or simple structural changes which have been changed in the building code from the time that the building was built until the time it is reconstructed. In short, even though in the exercise of caution an owner/Association attempts to purchase insurance coverage so that it can replace a hazard damaged building, through the purchase of replacement cost coverage, replacement cost coverage does not necessarily pay to completely replace the building damage.
The newer the building, the more likely the building will be code compliant. The older the building, the more likely the building will not be code compliant. What is an owner/Association to do? The short answer is that owners/Associations must be educated consumers and must understand what their insurance policy covers and does not cover.
When I first learned of this glaring problem, I found myself thinking “how can the property insurance companies get away with marketing a product named “replacement cost” and not actually be contractually obligated to provide the coverage which they advertise?” Consumers buy insurance to avoid the risk of loss. Insurers sell insurance to take on the risk of the loss that the consumer does not want to take. Is your insurance coverage going to pay for the damage that you sustain? Can you afford to battle with your insurer to claim insurance proceeds which are necessary?
We all live each day with the hope and expectation that we will not become the victim of fire or hazard damage. With the wild fires, hurricanes and mudslides, the prospect of hazard damage has become more of a reality. Insurance can be one of the most costly elements of most Associations’ budgets on any annual basis. Associations need to become informed consumers of their insurance coverage. Interview your insurance agent. Make them educate you about your coverage. Have the coverage explained as well as the differing costs of the coverage? Determine if your Association can afford to sustain the cost differential which may arise as a result of hazard damage under your replacement cost policy.
Rosemary A. Macero is an attorney who practices in Boston, Massachusetts. She represents various Condominium Associations.
1The hazards that are covered by the insurance contract are defined by the contract and are not discussed in this article.