Ordinance or law endorsements fill a major gap between the insured’s belief about replacement cost and the commercial property policy’s actual application of this valuation method. Disparity between the insured’s concept and the true operation of replacement cost often arises from the development, codification and enforcement of building codes.
Building ordinances and laws are enforced by local jurisdictions but the codes are promulgated by an assortment of contributors including: state government, federal codes and regulations and advisory organizations such as the National Fire Protection Association (NFPA). States use these sources to create the statutory infrastructure but endow local jurisdictions with the authority to adopt and customize building codes to meet local preferences as necessary.
Specific legal requirements stipulate the point at which a structure must be brought into compliance with local building codes. Correction of life safety issues presenting an imminent danger is generally required immediately regardless of surrounding circumstances; otherwise existing structures are usually granted “grandfather” status and are not required to comply with all applicable building codes unless certain statutorily specified events occur. “Major damage” to the building is one of those qualifying events.
Major damage does not have a universal definition; each jurisdiction establishes and applies its own meaning. There are, however, two broad categories of major damage into which most state and local building codes fall:
• The Jurisdictional Authority Rule: States using this as the measure of major damage allow the authority having jurisdiction (the local government) to judge when a damaged building must be brought into compliance with the current building code; and
• The Percentage Rule: When a building is damaged beyond a certain percentage of its “value,” the entire structure must be brought into compliance with local building code.
When government has the opportunity or feels the need to inject itself into issues related to property values – problems erupt as evidenced by these rules. Both rules present unique problems regarding insurance coverage and common policy provisions.
The jurisdictional authority rule is subjective in its application. Each jurisdiction applies its own standard to define major damage and determine a structure’s fitness for continued use. Decisions can be based on the amount of damage, the age of the building coupled with pre-loss compliance shortfalls or simple safety concerns. There is no one criteria upon which building owners and agents can depend, making risk management and insurance planning very difficult in these states.
Even the percentage rule’s definition of “value” differs among the states that apply this rule. “Value” could mean actual cash value, appraised value or market value. (Market value is negotiated between and agreed to by a willing buyer and a willing seller. It can fluctuate up and down based on the economy, condition, use or need and has little relation to the true cost to rebuild a particular structure. However, if market value is the rule applied, the agent must be prepared for and be able to explain this concept.)
Agents must know which rule of “major damage” is applied and how the individual jurisdictions apply the rule. Knowing this, the agent can explain the exposure and how replacement cost in the unendorsed property policy will and will not respond to losses triggering jurisdictional ordinance or law requirements.
Replacement cost alone falls far short of paying much of the additional costs necessitated by a major loss (as defined above and by the applicable law). Damage crossing the threshold of “major” effectively creates a constructive total loss of the structure; however, the unendorsed commercial property policy only pays to repair or replace the damaged property back to the condition that existed prior to the loss.
No coverage exists in the unendorsed policy to pay the loss in value of the undamaged portion of the building no longer useable (the insured loses the use and value of the undamaged part). The cost to tear down and remove the undamaged portion of the building from the site is also borne by the insured. Finally, the additional cost necessary to bring the building into compliance with the current building code is wholly paid from the insured’s financial resources.
Ordinance or Law endorsed to the commercial property policy assures the insured is indemnified (put back into the same condition enjoyed before the loss) for these expenses which would otherwise out-of-pocket. The endorsement’s three coverage parts close the commercial property policy coverage gaps highlighted above:
• Coverage A – Loss to the Undamaged Portion of the Building: The remaining portion of the building cannot be used due to application of the local building code; the insured is out the use value of this section making the building a functional total loss. This coverage part pays that loss of value;
• Coverage B – Demolition Cost: Once the undamaged portion of the building has been torn down it must be removed from the site. The commercial property policy only pays to remove damaged property, Coverage B pays the cost to tear down and remove the undamaged part of the building; and
• Coverage C – Increased Cost of Construction: All buildings must be built in compliance with applicable building codes. Buildings that suffer major damage are no exception. Replacement cost coverage only pays to put back what was there; this coverage part pays the additional cost necessary to bring the building into full compliance with current building codes.
Ordinance or Law coverage also fills the gap between the insured’s belief about replacement cost is and its customary application. Insureds must be informed of the exposures faced and the solutions available.
Building codes change and are updated frequently; the insured’s building can become non-compliant very quickly. Most commercial properties over five years old fail to meet current building codes. Major damage triggering the application of the jurisdiction’s laws or ordinances has the potential to cost the insured a large amount of out of pocket expense if the correct coverage is not provided; and the older the building is, the more expensive this gap in coverage.