The fifth question posed at the beginning of this series was "how are coverage limits chosen?" The next several paragraphs attempt to provide some guidance in this process.

Coverage "A" - Coverage for Loss to the Undamaged Portion of the Building
Coverage "A" does not require a limit be chosen. The endorsement pays the difference between the value of the damaged part of the property and the total building limit specified in the commercial property policy.

The real decision is made when the underlying commercial property limit is calculated. If the building limit chosen is too low, the combination of the commercial property limit and Coverage "A" will likewise be too low and may be subject to the coinsurance penalty.

Providing 100 percent insurance to value (ITV) assures the best opportunity to have adequate combined coverage. Using a reliable replacement cost estimator program coupled with knowledge of the local building trends are the best markers when choosing the initial limits of coverage.

Coverage B - Demolition Cost Coverage
What will it cost to tear down and removed the undamaged portion of the structure? The answer will depend on circumstances surrounding the loss and the characteristics of the structure, including:

• What does it cost within the local construction market to demolish a building and remove it from the site?
• How much of the building is not damaged?
• At what point will the jurisdictional authorities require the building to be torn down?
• Are there any special hazard issues such as asbestos, mold, etc?

For lack of a better term, the limit will be an "educated guess" based on the answers to these questions and other circumstances particular to a specific structure.

Purely for example sake and not intended as a recommendation or rule, the attached "Demolition Limits" example provides an example loss scenario.

Alter any or several factors in the attached example and the amount of required Coverage "B" changes.

Lacking any other plan or method, consider the following four-step process for calculating the amount of Coverage "B" to purchase:

1. Determine the "worst case" scenario. This is the minimum amount of loss necessary to trigger the application of the local building codes;
2. Convert the worst-case scenario amount into square footage. This conversion may not be exact, but it is necessary to calculate a limit;
3. Contact several local building and demolition contractors to develop an average cost per square foot for demolition and removal; and
4. Multiply the square footage developed in step "2" by the average cost per square foot for demolition and removal.

There is no guarantee that this will generate the exact amount needed, but it should be relatively close to the limit needed for most any loss.

Coinsurance does not apply to Coverage B and blanket limits are available; make use of these coverage part advantages where possible.

Coverage C - Increased Cost of Construction
Of the three coverage parts, choosing a limit for the increased cost of construction may be the most difficult to calculate. Several paragraphs within this series have touched on the difference between the true meaning of replacement cost within the insurance contract and the insured's understanding of and expectations of replacement cost. Coverage "C" is intended to provide the funds to finance the gap between reality and belief.

Perhaps the insurance industry is to blame for the misunderstanding of replacement cost. In fact, the industry is almost totally to blame due to the continued misrepresentation of the definition. Insureds are routinely told that replacement cost means new for old, either directly or by implication.

"Your building is insured for replacement cost. If it burns down, the insurance company will pay to build you a new building." An over-simplified definition of replacement cost promulgated over and over.

Often an agent or broker either doesn't know the application of the true definition or doesn't want to complicate the conversation by providing the definition and the applicable caveats; particularly that the unendorsed policy will only pay to "replace" what was there just prior to the loss, not any additional features required by building codes. There are times, though, when the agent/broker does detail this information to the insured, but the insured does not pay attention or does not remember the conversation. The insured hears what they want to hear and they create expectations of coverage based on what they "heard." (E&O Note: As a defense against E&O claims, consider inserting the entire definition of "Replacement Cost" in all proposals).

Where Coverage "B" involved an educated guess, Coverage "C" is devoid of any readily apparent avenues of educated information. Most replacement cost estimators develop and present the cost per square foot necessary to rebuild the building to current building code, with no method of deduction for its current "out-of-code" status. Further, the age of the building is not a reliable indicator as there may have been updates at different times throughout the years. To complicate matters further, it is not likely that any builder or contractor can provide an accurate estimate of what it might cost to rebuild the structure as it exists since all their cost estimators, like replacement cost estimators, are based on current codes. Lastly, with the time value of money and improvements in construction methods and materials, using old estimators and adjusting them to current values will not provide an accurate estimate.

Ultimately the limit chosen will be based on little more than a guess. One suggested "method" may be to assign a percentage of the building value and multiply that value by the age of the building. Some application or derivative of this "methodology" may provide the most explainable and defensible Coverage "C" calculation. Applying the same percentage to each year allows the ultimate percentage to account for fluctuations among the years regarding code changes. Some years may have seen major code changes with other years experiencing no code changes. This is akin to dollar cost averaging in financial planning.

For example, assume a chosen percentage of 1 percent per year on a 10 year old building. Applying the "cost averaging" method to a $500,000 building would produce a Coverage "C" limit of $50,000. Structures facing unique hazards, such as being located in a special flood hazard area (SFHA), may need to adjust the limit/percentage to respond to the extra hazard.

Coinsurance does not apply to Coverage "C" so there is no requirement to pick the exact limit. The goal is to mitigate, as fully as possible, the cost to the insured of bringing the building into compliance with the current building code following a "major" loss. For ease and to increase the chance of having an adequate amount of coverage, there is an option to purchase blanket Coverage "C" limits.

Coverage "A" does not require a limit choice as part of the endorsement; the choice is made in the underlying property policy. Coverage "B" is a somewhat educated guess. And Coverage "C" may be best described as a guess of irreducible complexity.

Claim Examples

Explaining the need for Ordinance or Law coverage and selling the insured on the additional premium may necessitate presenting a claim example. The attached example illustrates one loss with two potential outcomes; one if both Ordinance or Law endorsements apply and the second the possible outcome when only the commercial property policy and unendorsed business income coverage is used. For sake of the example, assume the building is correctly and fully insured and ignore any deductibles.

The attached example presents a very realistic claim scenario. With both Ordinance or Law endorsements in use, the insured is short only $30,000. Conversely, without the endorsements, the insured will be out of pocket $2,280,000 in actual costs and loss of income. By increasing their property premium by about 30 percent (that adds about $7,500 on a $25,000 property premium), the insured could have purchased $2,250,000 in additional limits.

One possible claim scenario yet to be discussed is one involving multiple causes of loss where some perils are covered by the underlying property policy and some portion of the loss is excluded from the CPP's coverage. The best and most recent example is the combination of wind and flood damage. In combined-loss situations such as this, the Ordinance or Law Coverage will pay pro-rata based on the percentage of damaged caused by each peril (once the court decides what that percentage is). If the wind causes 40% of the damage and the flood the other 60%, the Ordinance or Law coverage will pay 40% of the loss in all three coverage parts.

Conclusion

Structures built more than three to five years ago are most likely deficient in some aspect of the applicable building code. Ordinance or Law Coverage (CP 04 05) and Ordinance or Law - Increased Period of Restoration (CP 15 31) are very broad forms designed to financially address these deficiencies. Purchased together, these endorsements pay the additional costs and loss of income resulting from the application of ANY ordinance or law affecting the reconstruction of the covered structure.

Since 1) building codes have the potential to change rapidly; 2) not all jurisdictions apply the same rules of what constitutes major damage; 3) gaps exist in the coverage provided by the commercial property policy; and 4) the actual application of "replacement cost" is not completely understood or explained, these two endorsements could literally be the difference between the insured's ability to reopen following a major property loss and the business becoming a statistic.

More from this Series

1. Even Newer Structures May Not Meet Building Codes - Is The Insured Prepared?
2. Multiple Definitions Of "Major Damage" Creates Problems For Ordinance Or Law Coverage
3. Ordinance Or Law Limitations Don't Hurt Breadth Of Protection
4. Building Codes Often Increase The Cost And Time Of Reconstruction
5. How To Calculate The Correct Amount Of Ordinance Or Law Coverage