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Building Codes Turn Partial Property Losses into Total Losses

Author: Chris Boggs

Few commercial structures fully meet the applicable jurisdictional building codes and regulations of the county, city, town, borough, village or township in which they are located. Building codes are routinely reviewed, revised and updated, usually a result of newly developed technology or advances in construction methodologies or materials. Broad, sweeping building code revisions often are the response to a large-scale tragedy that resulted in a large amount of property damage, a massive amount of injuries, and/or the loss of many lives. Some codes exist and change simply because of jurisdictional preference necessitated by the scarcity of some natural resources (such as water usage control requirements) or due to increased hazards faced in that locale (such as exposures to wind and earthquake hazards).

Regardless of the source, federal, state or local, or the reason, all structures must be constructed in accordance with all building codes in force at the time of construction.

Without being too philosophical, the present becomes the past very quickly. The "fully" compliant building when built grows noncompliant in several aspects of its design and construction over time. The time required to move from "in" to "out" of compliance can range from only a few months to several years depending on the frequency and nature of changes to local ordinances or laws – local building codes.

Noncompliance has the potential to cost your insured building owner thousands of dollars in out-of-pocket expenses following a "major" property loss. "Major" is defined by the jurisdiction. The varying applications of "major" are detailed in a later section of this article.

Ordinance or law endorsement are designed to fill coverage gaps existing in the unendorsed commercial property policies and business income forms related to the additional costs and time associated with the enforcement of changes in local building codes. While the concepts presented in this brief article apply to virtually any commercial property policy or ordinance or law endorsement, coverage discussions in this article draw from Insurance Services Office's (ISO's) relevant forms and endorsements.

Coverage Gaps

Insurance policy exclusions exist for one of six reasons. One is directly applicable to the ordinance or law exclusions: the insurance company wants more information and more money before agreeing to provide the coverage.

All three commercial property causes of loss forms (basic, broad, and special) specifically exclude the increased cost of rebuilding, repair, or remodeling created by the application of an adverse building code. Likewise, the business income policy specifically excludes any increased loss of business income (as defined in the policy) resulting from the lengthened "period of restoration" due to construction delays brought about by the enforcement of such codes.

Unendorsed commercial property policies limit loss payments to the use of building materials of like kind and quality (LKQ), paying only to put back what existed just prior to the loss. Further, such unendorsed policies limit coverage to the part of the structure actually damaged—even when the jurisdictional authorities do not allow the undamaged part of the structure to remain, instead requiring what is still intact to be torn down (making a partial loss a total loss).

Likewise, the unendorsed business income policy pays only for the loss of income up to the point in time when the building should have been returned to "operational capability," absent any time extension directly related to the application of building codes. The "period of restoration" could be greatly increased as a result of and enforcement of local building codes.

As is probably evident, there is a high potential for uninsured, out-of-pocket building loss and additional loss of income when a structure suffering "major" damage is not in substantial compliance with the applicable building codes at the time of the loss. These additional expenses and loss of income have the potential to bankrupt a business, or at the very least cause devastating financial hardships.

"Major" Damage Defined

"Major" damage (or loss), as introduced above, is not necessarily a defined term in local building codes; it's simply the term chosen in this article to define the point at which the local jurisdiction considers a structure beyond safe repair due to age, condition, or previous compliance or noncompliance with building codes. This is the point at which the jurisdiction requires the entire structure be brought into compliance with current ordinances or laws – the point at which a partial loss turns into a total loss.

Local jurisdictions utilize state laws to decide the point at which "major" damage has been breached. Two of the most commonly used statutory guidelines for determining "major" damage are:

  1. The Percentage Rule: Simply, this rule states that if the subject building is damaged beyond a set percentage of its "value" or square footage, the entire structure must be brought into compliance with the current building code.
  2. Jurisdictional Authority Rule: Some state laws allow the "authority having jurisdiction" to decide at what point a structure has experienced "major" damage. This could be at 40, 50, or 60 percent of its value or square footage; or it could be based solely on safety, age, or zoning conditions. Several variations of this rule are used.

Of these two disparate statutes, the "Percentage Rule" would seem to be the easier to understand, plan for, and apply; but it's not. When "value" is used as the basis upon which the percentage is based, the definition of "value" differs among the states and even jurisdictions subscribing to this rule. "Value" may mean replacement cost, actual cash value, or appraised value; it could even be the tax value. Some states and even the federal government use "market value" (what a willing buyer will pay a willing seller) as the basis of "value." Still other states reference the "Building Valuation Data" manual published by the International Conference of Building Officials as the source for values.

"Jurisdictional Authority" states are even more complicated, introducing the problem of subjective opinion ("the rule of the person with the clipboard") into the application of local building codes. One local authority may choose to apply a percentage-type approach, while another may be far less objective in their decision process —making it a true guess as to the outcome.

Special Flood Hazard Areas (SFHAs), flood zones "A" or "V," complicate the application of the building codes in Jurisdictional Authority states. Buildings located in SFHAs suffering "substantial damage" (as defined by NFIP) must be brought into compliance with current flood plain management requirements as per 44CFR 59.1. The federal government defines the term "substantial damage" to mean "damaged beyond 50% of its market value."

Which rule takes precedence following a loss? Likely, the most stringent requirement. For example, the authority having jurisdiction may use and apply a rule that requires a building to be rebuilt if it is damaged beyond 50 percent of its square footage, but the flood plain management rules require the building to be brought into flood plain management requirements when it is damaged beyond 50 percent of its market value. If 35 percent of the structure is damaged, but the damage equates to 55 percent of its market value, then the entire building must be brought into compliance with all building codes. The reverse is also true; if the local code is somehow more stringent than the flood plain management code, then the structure must be brought into full compliance following a loss that triggers the local definition of "major" damage.

"Major" damage carries a wide variety of meanings across the country depending on the state and the attitudes of the local jurisdictions. Add the federal government's superimposed authority when a structure is governed by flood plain management requirements, and the need to understand and apply ordinance or law coverage becomes more apparent.

Without one common rule or even a consistent application among the jurisdictions subscribing to essentially the same rule, it is imperative that agents and/or building owners: 1) know the rules of the state or states in which properties are located, 2) understand how "major" damage is defined within that rule, 3) be aware of jurisdictional differences of opinion, and 4) be mindful of the application of flood plain management requirements.

Obtaining Ordinance or Law Protection

ISO utilizes two primary commercial property policy ordinance or law endorsements: 1) Ordinance or Law Coverage (CP 04 05) and 2) Ordinance or Law—Increased Period of Restoration (CP 15 31). There also exists a Business Owners' Policy (BOP) endorsement, the BP 04 06, which is essentially the combination of the two commercial property forms. Proprietary forms also exist in the marketplace.

Ordinance or Law Coverage (CP 04 05) provides three distinct coverages:

  • Coverage A—Coverage for Loss to the Undamaged Portion of the Building
  • Coverage B—Demolition Cost Coverage
  • Coverage C—Increased Cost of Construction

Coverage ACoverage for Loss to the Undamaged Portion of the Building

Coverage A responds when a major loss triggers the application of the local ordinance or law, yet part of the building is undamaged. Essentially, the actual loss in such a claim is not just the value of the damaged part of the structure, but the value of the entire structure since the remaining structure has been rendered unusable by application of the local building code.

Coverage A's payment following a "major" damage loss relates directly to the policy limit of the underlying property policy. In essence, the maximum the insured can be paid is the total limit of coverage listed in the commercial property policy. The ultimate amount paid is a function of: 1) the location jurisdiction's rule of major damage, 2) the actual amount of damage, and 3) the insured value of the building. Following is a simplified example of the application of this "limit" rule.

Coverage B—Demolition Cost Coverage

Coverage B fills the gap created by and between the commercial property policy and Coverages A and C of the Ordinance or Law coverage. Specifically, Coverage B pays the cost to demolish the undamaged portion of the partially damaged structure and remove it from the premises.

When a "major" loss occurs, the commercial property policy and Coverages A and B of the Ordinance or Law Coverage endorsement apply concurrently as illustrated below to ready the site for the replacement structure.

Commercial Property Policy (CPP) pays:

  • The value of the actual damage to the insured structure
  • The cost to remove the debris of the damaged structure

Ordinance or Law—Coverage A pays:

  • The value of the undamaged part of the structure rendered unusable and valueless by the application of any ordinance or law

Ordinance or Law—Coverage B pays:

  • The cost to tear down the undamaged part of the structure
  • The cost to clear the site of the debris resulting from demolition of the undamaged part

Once the site is clear, construction on the new structure can begin.

Coverage C—Increased Cost of Construction

This third leg of ordinance or law coverage represents and provides the funds necessary to pay the difference between the replacement cost as defined in the insurance policy and the insured's belief about and understanding of its meaning. In short, Coverage C pays the costs in excess of the amount paid by the underlying commercial property policy necessary to bring the damaged structure into compliance with the building code in effect at the time of loss. Without Coverage C, the insured would have to pay these additional building costs out-of-pocket.

Coverage C has the added benefit of extending protection for some classes of real property specifically excluded in the commercial property policy including: the cost of excavations, grading, backfilling and filling, building foundations, pilings and underground pipes, flues and drains to the list of insured property.

Further, it is possible to have an ordinance or law claim and payment under Coverage C only without the need for payout under Coverages A or B. The three types of losses to which Coverage C responds are:

  • The cost to repair or reconstruct the damaged portion of the building;
  • The cost to reconstruct the undamaged portion of the building if demolition is required; or
  • The cost to remodel the undamaged portion of the building if demolition is not required.

Three caveats must be satisfied before Coverage C applies:

  1. The rebuilt or remodeled property must be intended for similar occupancy (unless such occupancy is no longer permitted);
  2. To receive payment under Coverage C, the building must first be rebuilt or remodeled. There is no option to take the actual cash value (ACV) of the upgrades such as exists in the commercial property policy and Coverage A. If the insured decides to not rebuild, the insured will receive the ACV of the damaged part of the building from the commercial property policy; plus the ACV of the undamaged portion of the building (paid under Coverage A); and
  3. Repairs or replacement must be made as soon as reasonably possible, but they must be completed within two years after the loss. If it appears that more than two years is required, the insured can request an extension. The insurer will evaluate the request based on the conditions surrounding the request and may or may not grant the extension.

The insured can choose to rebuild anywhere; but the most Coverage C pays (subject to the limit of insurance purchased) is the increased amount necessary to replace the building at the insured premises. If, however, the local ordinance or law requires the building be relocated, then this coverage part will pay the lesser of the increased cost at the new premises or the limit of coverage.

Since the goal of Coverage C is to replace the damaged building with an improved one, the underlying property coverage must be written on a replacement cost basis, preferably insured at or near 100 percent of insurance-to-value (ITV). Doing so will remove most limit gaps and coinsurance problems. Notice, however, that the coinsurance condition does not apply to Coverage C.

Ordinance or Law—Increased Period of Restoration (CP 15 31)

As its name suggests, this endorsement redefines the Business Income Policy's definition of "period of restoration" to include any increase in such period resulting from the application of any ordinance or law. Simply stated, if the building code lengthens the "period of restoration," the income lost during this extended period is included in the definition of "business income." Without this endorsement, income lost during this extended period is paid out of the insured's pocket.

Protection provided by both endorsements (CP 04 05 and CP 15 31) responds only if: 1) the loss is caused by a covered peril (regardless of the form used); 2) the loss breaches the "major" damage threshold as defined and applied by the subject jurisdiction; and 3) the damaged structure is lacking in some aspect of the local building code in effect at the time of the loss.

Any loss satisfying all three triggers activates the ordinance or law coverage. However, two additional coverage-limiting provisions require explanation:

  1. The endorsement pays only to the point necessary to meet the minimum code requirements applicable to the structure. Any costs associated with going over and above the minimum code are borne by the insured. If, for example, the insured is not required by the building code to install a sprinkler system, but does anyway, the additional cost of the system is not covered by the ordinance or law endorsement because the insured is not installing it to meet code; and
  2. Any costs to meet codes that were required to be met prior to the loss, but weren't, are borne solely by the insured. For example, if the insured was directed by the jurisdiction to install a sprinkler system before the loss but didn't, the policy won't pay for its installation after the loss. This would violate indemnification since this is an expense the insured should have had before the loss.

A MOST Important Property Coverage Option

Ordinance or Law is the second most important property option following business income coverage. However, its importance is rarely recognized – until after the loss; when the partial loss becomes a total loss.

The Virtual University recently hosted a webunar on this very topic - When (and Why) Partial Losses Become Total Losses. When (and Why) Partial Losses become Total Losses - This webinar covers Ordinance or Law Coverage issues. Contact your Big I state education director for more information on how to register. 

  • The coverage gaps in property policies making Ordinance or Law Endorsements necessary;
  • Who promulgates and who enforces local building codes;
  • What constitutes "major" damage;
  • The details of various ordinance or law endorsements;
  • How to develop coverage limits for each coverage part; and
  • The approximate additional premium for each coverage.

Several states offer CE for this session. And remember, every registrant receives a link to the record and a transcript for your ongoing reference.

Last Updated: January 18, 2024

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