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People buy insurance to cover losses, but how much insurance companies pay depends on the contract and the amount of the loss. With some policies, the payout is easy to determine. Life insurance pays the face value of the policy when the insured dies. Liability insurance pays legal costs and any assessed liability damages up to the policy limit. Business income insurance pays for damages and losses in income because of the damage. However, determining the payout for property losses is more complicated; how much is paid is determined by the principle of indemnity.
Probably the most basic and fundamental principle of property insurance—and why property insurance even exists—is that of indemnity. The basic purpose of insurance is to cover a loss that an insured has suffered. Indemnity is the payment of a loss by the insurer to the insured, but for no more than what the loss actually is. Indemnity compensates the insured for loss, but does not allow the insured to make a profit out of the loss. If the insured could profit from a loss, then the insured may actually cause the loss to make a profit, or be complacent in preventing a loss. Thus, to allow the insured to collect more than their losses would create a moral hazard, which would be against public policy, and would drive up premiums to unaffordable prices.
In property insurance, the amount of the indemnity is typically based on the actual cash value of the loss at the time of the loss. Over the years, the courts have used 3 methods of determining actual cash value: replacement cost less depreciation; fair market value; and the broad evidence rule. Generally, the applicable rule is the one that pays the least to the insured—not so insurance companies can save themselves money, but because to pay more would violate the principle of indemnification and create moral hazard.
If a 3 year old car is totally demolished, the insurance company is only going to pay what the car was worth at the time of its loss. If it paid the full value of a new car, this would create a moral hazard by motivating some drivers to intentionally destroy the car in an attempt to profit from insurance. In many cases, the insurance company will determine the actual cash value by subtracting depreciation from the replacement value of the car. Replacement cost is the current price of a new item. Depreciation is the decrease in the market value of an item because of wear and tear. Note that this is different from depreciation as used in accounting and for tax purposes, because it does not depend on the purchase price of the item. Depreciation is calculated as the age of the item divided by its useful life.
| Depreciation and Actual Cash Value Calculated for Insurance Purposes | ||
|---|---|---|
| Depreciation = Replacement Cost x | Age of Insured Property ──────────────── Useful Age of Property | |
| Actual Cash Value | = | Replacement Cost - Depreciation |
Thus, if a new car costs $20,000, and the depreciation of the 3 year old car is $5,000, then the insurance company is only going to pay $15,000 for the totally demolished car. To pay more would violate the principle of indemnification.
Depreciation also applies to partial losses to realty, such as buildings and other structures on land.
A 10 year old building with a useful life of 40 years and a replacement cost of $120,000 suffers a partial loss of 50% due to fire. What would be the indemnification for this loss?
Solution:
Sometimes, property loses value for reasons other than depreciation—in many of these cases, fair market value is used to calculate cash value. Fair market value is the price that a property would fetch in an open market. For instance, because of urban decay and higher taxes, many people do not want to live in many larger cities, which causes the property values in those cities to decline well below their replacement cost. If an insurance company paid a replacement cost minus depreciation that was higher than the fair market value of the property, then some property owners would be tempted to destroy their property to get the higher insurance value over what they would get selling it in the market.
Sometimes a fair market value is difficult to determine, or there is a question as to what the fair market value is. In these cases, the courts have used other evidence in determining a value for the loss. The broad evidence rule uses all relevant factors in determining the cash value for the loss, which can include, appraisals, income generated by the property, and anything else that could potentially affect the value of the property. The factors used are what an expert would use to determine the value of a property.
Sometimes, the principle of indemnity is not easily applied or cannot be applied because of the nature of the insurable interest, because of state law, or because the insured wants greater protection than afforded by indemnification.
Some things are difficult to price—antiques, paintings, heirlooms, etc. To insure these items, the insured can get a valued policy, which pays the face amount of the policy when a total loss occurs. To prevent moral hazard, the insurance company and the insured must agree what the value is before the policy is issued.
Some states have valued policy laws for real property that requires insurance companies to pay the face value of the policy if there is a total loss to the property due to a peril specified by law—which can include fire, lightning, windstorms, tornadoes, and hurricanes.
Valued policy laws were enacted to prevent disputes about the worth of the property when a total loss occurred. Many properties were overinsured by agents wanting to earn larger commissions. When a loss occurred, the insurance company would inspect the property and find that it was worth less than its insured value, and was, therefore, only going to pay what it was worth. While the valued policy laws helped to prevent such disputes, they create a moral hazard by insuring the property for more than it’s worth—owners would have a lax attitude toward preventing loss, or may even cause the loss for profit. However, real estate inflation does mitigate this hazard—in fact, many properties become underinsured after a few years.
Insurance is purchased to protect against major losses. However, many insureds would still have substantial losses after receiving payment from the insurance company because the typical payment will not cover the depreciated value of the property. In many of these cases, the insured will have to replace the property for substantially more than what they received in insurance. This is especially true for real estate because of location, neighborhood, or, if it is a factory, or some other building used in the production of goods, obsolescence of its machinery. To remedy this situation, insurance companies offer replacement cost insurance.
Replacement cost insurance pays for the replacement value of the loss, without any deduction for depreciation. To lessen moral hazard, replacement cost insurance often has stipulations designed to lessen moral hazard. With real estate, for instance, replacement cost insurance will often require the insured to rebuild in the same place.
However, because some old buildings would cost more to repair than their market value, insurance companies will generally pay for modern construction techniques to replace or repair old buildings—functional replacement. A good example of this is the HO-8 homeowner's insurance policy.
The HO-8 (aka Modified Coverage Form) policy is for older homes that have a replacement cost that is much higher than its market value. To prevent moral hazard, insurers will not insure a home for more than what it is worth. The HO-8 policy solves this problem by paying what it would cost to repair or replace damaged property, using common construction materials and methods. HO-8 provides functional replacement, which is cheaper. For instance, plaster walls may be replaced with drywall and hardwood floors could be replaced with plywood.
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