Collecting Replacement Cost Funds
Replacement by Substitution - Commercial Property
Question: An insured whose building was heavily damaged by fire has found another suitable structure which, after remodeling would become a replacement for the one that has been damaged. The insurance company says that they will pay the cost of the acquisition, but that the building coverage will not extend to include the price of the improvements at the new site.
The values of the two sites, the old one and the substitute, are generally equivalent and so are the outbuildings; thus the transaction represents and even trade from that standpoint. So, in essence, what the insurer is being asked to do is to allow the insured to spend the dollars improving the substitute site that would have been spent in repairing the original. Yet, the insurer is balking at the transaction.
Answer: Standard forms offering replacement cost stipulate three limits, agreeing to pay whichever is least. In the language of the commercial property form of Insurance Services Office (CP 00 10 06 95) coverage responds to the lesser of:
The second limitation applies to replacement on the same premises. By its lack of a similar condition, the third limitation opens the promise to replacement at any site. (When the concept of insuring for "replacement cost" was first introduced, the third limitation was, like the second, restricted to replacement "on the same premises and intended for the same occupancy and use." - e.g., Form SMP No. 12 Ed 10 62. The subsequent elimination of this part of the third limitation was an immediately accepted signal that replacement off premises would be allowed).
Consequently, if the third category expenditure is both less than the coverage limit and less or even equal to the price of repairs at the original site, then the conditions of the policy are met and the insured may make the move.
The word "necessary" might seem to be a curious entry in the third limitation. Since it is not defined in the policy so as to give the insurer a say about what may be thought of as "necessary", that judgment seems to be left to the insured. But that is appropriate. Protection for the insurer is contained in limitation 1. It will pay no more than the applicable limit stated in the contract. Whether the insured elects to repair the damage to the existing structure or move off site, the insurer's possible maximum loss is not affected.