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When Insurance Strikes (Out): Underestimating Replacement Cost

Author: Chris Boggs

Brace yourself for this opening line from a recent NY Times Article entitled, Now Comes the Insurance Challenge: "Hundreds of anguished Californians who lost their homes in an outbreak of wildfires this week now get to face another burden: dealing with insurers."

News reporting has slowly slipped into opinion sprinkled with specks of news. I earned and graduated with a journalism degree; in my news writing class two rules were forced upon and drilled into me regarding news reporting: 1) never use adjectives that aren't fact based, because they are nothing but opinion; and 2) never report your opinion – unless you are writing an editorial or opinion piece.

Evidently this reporter forgot his training – or never received any. The first line contains an unnecessary adjective, "anguished," which does not add anything factual to the story. And then to postulate that dealing with insurers is a burden on par with suffering the fire loss is pure opinion. The writer openly displays his beliefs rather than sticking with facts; effective news reporters know how to write a compelling story without passion or prejudice infecting their words.

Ultimately the crux of this "reporter's" story is CoreLogic's assessment that approximately 60 percent of homes are underinsured by 20 percent on average. This fact alone makes this a compelling story without the reporter needing to insist the reader wade through his opinion. Unfortunately, homeowner underinsurance is not a new phenomenon, the VU has highlighted this issue for several years. 

To drill his opinion and evident dislike for insurance carriers and their agents even deeper into the reader's mind, the author sources the executive director of United Policyholders (UP) stating that homeowners are sometimes misguided by their agents. According to UP, agents sometimes rely on replacement cost formulas that don't capture all the costs necessary to rebuild.

Yes, agents are generally required by the insurance carrier to develop the Coverage A limit. However, agents are not asked to do this without tools provided by the carrier or purchased from vendors such as CoreLogic. When the information is input correctly, the developed Coverage A limit is relatively accurate. Issues arise when information is improperly input or the agent alters the information to "develop" a desired limit.

Regardless if the accusation that agents intentionally misguide their clients is true or not, the continual publication of such negative press ultimately results in belief among insurance buyers. Readers will eventually begin to believe they are being misguided by their agents.

Unfortunately, the VU has been alerted to situations where insureds are, in fact, purposely misguided by their agent. We received the following question on our Ask An Expert:

Q. Recently we have run into a handful of agents who are intentionally underinsuring homes, then using an Extended Replacement Cost endorsement to increase the Coverage A limit 50 percent. They tell the insured that their $750,000 house with a Coverage A limit of $500,000 is really insured for $750,000. The insured saves $100s in premium with the $25 added endorsement.

I have always believed these endorsements were intended to offset a spike in construction costs when a catastrophic event occurs, such as a tornado striking an urban area. I can only assume the intent was not to be a tool to decrease Coverage A, and thus the premium.

My question is how would this impact the insured, if at all, should they have a large claim? Any standard ISO Homeowners policy states that the home must be insured to 80% of the actual cost to rebuild for Replacement Cost to apply. So, when the carriers determine this are they factoring in the Extended Replacement Cost endorsements? Or is it strictly off of Coverage A?

The VU's responses:

A. These agents are in violation of ISO rules specific to these endorsements, the requirements of the policy language and the intent of the endorsements. In short, these agents are committing fraud.

Rule 407 addresses both ISO-based "Guaranteed" Replacement Cost endorsements (HO 04 11 and HO 04 20); the rule specifically states: "When either of the following options is selected, the Coverage A limit of liability shall be at least 100% of the full replacement cost of the property insured under Coverage A at policy inception or at the time the endorsement is added to the policy." It is clear these agents are violating the rules. Not only are they breaking ISO, and likely carrier, rules and guidelines, they are misleading their insureds.

Agents engaging in the described practice are also violating policy language. Both the HO 04 11 and HO 04 20 specifically state that the additional limits apply as follows: "To the extent that coverage is provided, we agree to provide an additional amount of insurance in accordance with the following provisions:

"A. If you have:

1. Allowed us to adjust the Coverage A limit of liability and the premium in accordance with:

a. The property evaluations we make; and

b. Any increases in inflation; and

2. Notified us, within 30 days of completion, of any improvements, alterations or additions to the building insured under Coverage A which increase the replacement cost of the building by 5% or more; the provisions of this endorsement will apply after a loss, provided you elect to repair or replace the damaged building."

To garner the additional protection, the insured must agree to use the property valuations completed by the insurance carrier. If the agent is either not providing the valuations or are altering them to get the value they want, that is a material misrepresentation or even fraud. If the carrier is complicit, that's an even bigger problem.

You are correct about the intent of the endorsements; they were designed to be safety nets, not as a primary source of recovery. This is evident by the rate structure; the carrier plans to be paid the required premium because the amount of coverage is supposed to be written to 100 percent of the value. The carrier is victimized by this undervaluing practice because they are only paid an additional 3 percent of premium for the "up to" 50 percent increase in Coverage A. If this becomes a wide-spread practice, the carrier's rates will be adversely affected. 

As to how this misuse (fraud) will play out in a large property claim, that's not clear. Effectively the 80 percent requirement (what we call the coinsurance requirement) is removed from the policy wording by attachment of these endorsements – because the carrier anticipates coverage to 100 percent of the value. There is some potential that the carrier could void the endorsement for misrepresentation and failure to comply with the rules and policy language. If they do, the coinsurance provision will be imposed on the insured. But there is no guarantee this action will be taken (even though it should). (I wonder if agents are depending on the provision stating that the policy premium will be increased to cover the additional limits in the hopes this will avoid any problems from the carrier.)

One proprietary Extended Replacement Cost form uses this parenthetical phrase in the endorsement: (Applies only when loss to dwelling exceeds the Coverage A Limit of Liability shown in the Declarations). It appears that if there is a partial loss, the 80 percent insurance-to-value (coinsurance) clause is reinstated and the insured could be subject to a severe penalty.

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Hopefully, the agents committing this type of fraud are not independent agents. Certainly, they are not readers of this newsletter.

Factors beyond the agent's control can also result in improper limits. Additions or changes made to the structure by the insured can and does increase the replacement cost. Often the insured makes changes and then fails to notify the agent or the agent fails to ask. If the agent asks about changes annually (in conversation, by letter or by any other means), the fault lies with the insured for not disclosing the changes. If the agent does not inquire about changes, the shortfall may be, and likely will be the fault of the agent, but failure to ask is not equivalent to intentionally misguiding a client.

An E&O Perspective

Errors and omissions (E&O) recommendations and industry practices appear to conflict in regard to developing and choosing coverage A limits on a homeowners' policy.  E&O experts contend: 

  • Agents should NEVER calculate the coverage limits. How much insurance a customer needs is up to them. The agent should ask the insured how much they think they need, discuss their exposures, and give them options. The ultimate decision is up to the individual. While the agent can use estimators to help the customer determine what they might want to have, the decision must always and ultimately be the customer's.

While I agree with the views of our E&O experts, industry practice often conflicts with this recommendation. When I was an agent, the carriers required the agency to complete a replacement cost estimator on every homeowners' policy, the developed value was treated like an indisputable fact. As the agent, I wasn't allowed to alter the developed value. But if it was wrong, it was my fault. If this is no longer industry practice, please pass along the current practice.

A third party to the Coverage A debate is the mortgagee. The bank may attempt to force the agent to write a Coverage A limit equal to the loan amount. There are several reasons this may be improper: 1) the closing price of a house is its market value (a willing buyer and a willing seller) and may have not correlation with the cost to rebuild the house following a catastrophe; 2) the selling price includes land which is not insurable under Coverage A; and 3) doing this may violate laws. Earlier this year the VU addressed this mortgagee requirement; click here for more details including the state laws currently in place.  

For sake of this discussion, we are ignoring the banks.

An Agent's Checklist

While I do not believe most agents intend to misguide their clients (as asserted in the NY Times article), the fact that CoreLogic states that such a high percentage of houses are underinsured is evidence that underinsurance is a serious problem. To avoid being compared with a wildfire, agents should:

  • Have and use the proper cost estimator tools. Make sure they are kept up to date.
  • Learn how to property use the tools. Contact the vendor or carrier to train your staff.
  • Discuss the developed Coverage A limit with the carrier AND the client. Have the insured and the underwriter agree to and sign off on the chosen limit (in writing – literally).
  • Use one of the "guaranteed" replacement cost endorsements to avoid underinsurance. They are inexpensive and provide the insured and you with a margin for error.
  • Consider the Inflation Guard endorsement
  • Ask every year if there have been any changes or updates to the structure.
  • Remember to discuss the ordinance or law exposure (not detailed in this article). 

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Last Updated:  October 27, 2017

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