3.3 Methods of Valuing Losses and Writing Limits
Loss Valuation
A property insurance policy pays covered losses according to the valuation method stated in the policy. This method is usually explained in the Loss Settlement condition, which describes how the insurer will determine the amount payable after a covered loss. In some cases, the insured may choose a different valuation method by adding an endorsement to the policy. When this occurs, the policy will settle losses based on the valuation method selected in the endorsement, subject to the terms and limits of the policy.
Actual Cash Value (ACV)
When a covered loss is settled on an actual cash value basis, the policy pays the cost to repair or replace the damaged property as of the time of the loss, minus depreciation. Depreciation reflects the reduction in value caused by factors such as age, wear and tear, condition, or obsolescence. As a result, an actual cash value settlement may be less than the amount needed to replace the damaged property with new property of like kind and quality.
Replacement Cost
Replacement cost is a property valuation method that pays the full cost to repair damaged property or replace it with property of like kind and quality, using current prices and without deducting for depreciation. Many property policies that provide replacement cost coverage require the insured property to be insured to a specific percentage of its full replacement value, such as 80%. This requirement helps ensure that the property is insured for an adequate amount. In some policies, losses are automatically settled on an actual cash value basis. When this occurs, replacement cost coverage may be available by endorsement, allowing the insured to add or select this valuation method for covered property.
Example
An insured's television is totally destroyed in a covered fire loss. The television was purchased five years ago for $1,500 and had an expected useful life of 10 years. Because five years have passed, the television has lost 50% of its useful life. At the time of the loss, a comparable new television costs $2,000.
If the insured has replacement cost coverage, the insurer would pay the current cost to replace the television with a comparable model: $2,000.
If the insured has actual cash value coverage, the insurer would subtract depreciation from the current replacement cost. Since the television has depreciated by 50%, the insurer would pay 50% of the current replacement cost:
50% of $2,000 = $1,000
Therefore, the actual cash value settlement would be $1,000.
Functional Replacement Cost
Some properties, such as older dwellings or Victorian homes, may have been built with materials or construction methods that are no longer commonly used. Restoring these properties to their original condition after a loss may be extremely expensive or impractical because the original materials, craftsmanship, or building techniques may be difficult to find or costly to reproduce. For this reason, these properties may be insured on a functional replacement cost basis. Under this valuation method, the insurer pays the cost to repair or replace the damaged property with a modern equivalent that performs the same function, rather than paying to restore the property exactly as it originally existed.
Guaranteed Replacement Cost
Guaranteed replacement cost is a loss valuation method that pays the full cost to replace the dwelling after a covered loss, even if the replacement cost is greater than the policy limit. This makes guaranteed replacement cost broader than other valuation methods, which generally do not pay more than the applicable policy limit. Because this coverage may require the insurer to pay above the stated limit, the insured is often required to allow the insurer to determine the dwelling's replacement cost value and adjust that amount as needed over time. These automatic adjustments help keep the coverage amount aligned with current construction costs. Guaranteed replacement cost coverage is not available in every state and may not be offered by every insurer.
Agreed Value
Some property insurance policies insure covered property for an agreed value or agreed-upon policy limit. Under this valuation method, the insurer and insured agree on the value of the property when the policy is issued. If a total covered loss occurs, the policy pays the agreed amount, regardless of the property's actual cash value at the time of loss. This valuation method is often useful for property that is difficult to replace, appraise, or value using standard methods. Examples may include fine art, paintings, antiques, collectibles, and classic automobiles.
Policies written on an agreed value basis are often referred to as valued policies. In a valued policy, the insurer and insured agree on the value of the covered property before a loss occurs. If the property is totally destroyed by a covered loss, the policy pays the agreed value, subject to the terms and conditions of the policy.
Stated Value
Stated amount valuation is a loss valuation method in which the insurer bases the policy premium on the value stated by the insured. The insured identifies the property's value when the policy is written, and that stated amount is used to help determine the premium. However, stated amount valuation is different from agreed value coverage. Under a stated amount policy, the insurer will pay the lesser of the stated amount or the property's actual cash value at the time of loss. This type of valuation may be less expensive than agreed value coverage, but it may also provide less protection. If the property's actual cash value is lower than the stated amount, the insured may not receive the full amount listed on the policy.
Market Value
Although it is less common than other loss valuation methods, some property insurance policies value covered property based on its market value. Market value is the price that a willing buyer would pay to a willing seller under fair and normal market conditions. This valuation method may be used when the value of property changes based on supply, demand, or other market factors. For example, market value may apply to goods or commodities whose prices fluctuate, such as agricultural products, livestock, or other items commonly bought and sold in an open market.
Salvage Value
Salvage value is the amount property may be worth at the end of its useful life or after it has been damaged. In property insurance, salvage value generally refers to the remaining value of damaged property, often based on what the property could be sold for as scrap, parts, or reusable materials. For example, if damaged equipment can no longer be used for its original purpose but can still be sold for parts, the amount received from that sale would represent its salvage value.
Property Insurance Limits
Property insurance policies may provide coverage limits in several different ways. The type of limit used depends on the insured's property, the amount of coverage needed, and how the policy is designed to respond to a covered loss. Understanding how coverage limits apply is important because the limit determines the maximum amount the insurer will pay for covered property damage or loss, subject to the policy's terms, conditions, and exclusions.
A specific limit provides one separate limit of insurance for one specific item or type of property. This means the policy identifies the covered property and assigns a single coverage amount to that property. For example, a dwelling policy may insure one dwelling for a specific limit of $100,000. In that case, the $100,000 limit applies only to that dwelling, subject to the policy's terms, conditions, and exclusions.
A blanket limit provides one total limit of insurance that applies to multiple items of covered property. Instead of assigning a separate limit to each item or location, the policy uses one shared limit for all property included under the blanket coverage. Blanket limits may apply to property located at different locations, different types of property, or both. For example, a blanket limit may cover two buildings at separate locations, the business personal property inside each building, or a combination of buildings and business personal property. Example: A business has a $1 million blanket limit that applies to two separate buildings at two separate locations, including the business personal property contained in each building. The $1 million limit is available to respond to covered losses involving any of the property included under the blanket limit, subject to the policy's terms, conditions, and exclusions.
Scheduled limits insure multiple items of property under one policy, with a separate limit of insurance assigned to each item. These limits are usually listed, or “scheduled,” in the policy Declarations. Unlike a blanket limit, which provides one shared limit for multiple items of property, scheduled limits apply individually to each listed item. Example: A farm policy may insure the residential dwelling for $100,000 and a barn for $200,000. Each structure has its own separate coverage limit, as shown in the policy Declarations.
| Limit Type | Number of Properties | Number of Coverage Limits |
|---|---|---|
| Specific Limit | One | One |
| Blanket Limit | Multiple | One |
| Scheduled Limit | Multiple | Multiple |
Deductible
Before an insurer pays a covered property claim, the insured is usually responsible for paying a deductible. A deductible is the specific amount of a covered loss that the insured must pay or absorb before the insurer makes payment. Deductibles are used to share part of the cost of a loss with the insured and are often applied to each separate occurrence. In most property insurance claims, the insurer subtracts the deductible from the total amount of the covered loss when calculating the claim payment. For example, if a covered loss totals $10,000 and the policy has a $1,000 deductible, the insurer would generally pay $9,000, subject to the policy's terms, conditions, and limits.
Example
A homeowners policy has a $100,000 limit of insurance and a $250 deductible. If the insured has a covered loss of $110,000, the insurer would pay the policy limit of $100,000. Even though the loss is greater than the policy limit, the insurer is not required to pay more than the maximum amount provided by the policy.
If the insured has a covered loss of $1,000, the insurer would subtract the $250 deductible from the loss amount. In that case, the insurer would pay $750:
$1,000 covered loss − $250 deductible = $750 claim payment
Deductibles are an important underwriting tool used by insurers to help reduce the number of small claims submitted under a policy. When insureds are responsible for paying a portion of each loss, they may be less likely to file claims for minor damage. A high volume of small claims can increase an insurer's administrative costs, affect the overall cost of providing coverage, and may contribute to moral hazard if insureds become less careful because they expect the insurer to pay for every loss. Reducing small claims also helps preserve the insurer's ability to respond to larger and more serious claims. In many cases, an insured may reduce the policy premium by choosing a higher deductible. This is because the insured agrees to assume a greater portion of each covered loss before the insurer is required to pay.
Note
Deductibles are most commonly associated with property insurance policies. They require the insured to pay a specified portion of a covered property loss before the insurer makes payment. Deductibles generally do not apply in the same way to casualty insurance policies, which primarily provide liability coverage for claims made by others against the insured.