Author: Chris Boggs

Property can be assigned many “values" depending on the purpose of the valuation and who is valuing it. Some examples include:

• The amount for which the property could be sold; known as “market value." Market value is what a willing buyer will pay a willing seller.
  
• What an expert thinks it's worth. In simple terms, this is “appraised value." A property or business appraiser evaluates the subject property based on local market conditions, estimated income, cost to build from the ground up and other comparison calculations.
• The value to the individual who owns the property. This is intrinsic value, what a certain piece of property means to you or me in terms of memories and significance.
• The cost to replace the property with new property just like or similar to the property. In insurance terms, this is often called replacement cost.
• Depreciated value. Depreciation has a dual function as it relates to property values. Accountants use depreciation as a business “expense" that lowers taxable income. But depreciation plays a part in insurance as well; it is generally applied within the concept of Actual Cash Value.
• The cost to replace the property with something functionally equivalent. Can the owner replace a hardwood floor with subfloor and linoleum and be just as happy or accomplish the same goal?
• The value assigned for tax purposes. This is a jurisdictional value municipalities use or assign to calculate or create tax-related income.

Although not necessarily a complete list of possible property values, these seven cover the majority of “values" assignable to any particular property. But we, as insurance professionals, are primarily concerned about only four of these:

• Actual cash value
  
• Replacement cost;
• Functional replacement cost; and
• Market value.

Actual Cash Value

Actual cash value has historically been defined as the cost new, on the date of the loss, minus physical depreciation. "Physical" is highlighted because there are many different types of depreciation that don't relate to insurance: depreciation due to obsolescence, accounting depreciation and economic depreciation. Physical depreciation results from use and ultimate wear and tear - meaning that the insured does not get paid for the "used up" value of the property.

Pay attention to the beginning point in the calculation of ACV, the cost new on the date of the loss. ACV is not based on the value when it was purchased or at any point between that date and the date of the loss. Only the cost new on the date of the loss matters.

However, ACV is not always calculated in this method. In fact, ACV can be developed in one of four ways:

1. Applying the Broad Evidence Rule;
   
2. Equating ACV to a property's Fair Market Value;
3. Applying the historical definition of replacement cost minus physical depreciation; or
4. Equating ACV with replacement cost.

Each of these is discussed in the VU article, Why Defining Actual Cash Value is Amazingly Difficult. This article also links to a state-by-state breakdown of which method applies in each state. The most common is the Broad Evidence Rule.

ACV is the common basis of valuation for:

• The unaltered commercial property policy
  
• Coverage C in all unendorsed Homeowners' (HO) coverage forms
• Non-building other structures under Coverage B of the HO forms (but can be endorsed to replacement cost)
• Auto physical damage

Replacement Cost

Replacement cost is often described as “new stuff for old junk." This is really an oversimplification of the replacement cost concept. Yes, the insured does get paid to replace something old with something new due to the purpose of insurance – indemnification.

Indemnification is the contractual obligation of one party (the indemnitor) to return another party (the indemnitee) to essentially the same condition (financial or otherwise) enjoyed before the loss, with no improvement or betterment. Within property policies (which are called first-party policies) the insurer is the "indemnitor" and the "indemnitee" is the insured.

Replacement cost may be the truest form of property indemnification when considered this way: the insured's machinery is destroyed by fire, now they have no means to conduct business and generate revenue; the insurance proceeds don't necessarily do any good, they need the equipment. Same with the building, the insured needs a building in which to operate, not the money. Replacement cost is the best mechanism for returning the building and contents to the insured so they can resume operations, regardless of the type of operation (manufacturer or office). This is the best demonstration of the goal, purpose and representation of indemnification.

Still, how can replacement cost embody the principle of indemnification? Isn't the insured better off than before the loss? Valid questions.

Indemnification principles are not violated by replacement cost and, in fact, are upheld because the amount of insurance purchased equals the cost new of all eligible insured property on the day of the loss. Basically, the insured is valuing as if it were new and paying a premium based on that value.

Replacement cost generally applies to:

• Coverage A in the HO policy forms (except HO-8)
  
• Building structures in Coverage B of the HO policy
• By endorsement for Coverage C in the HO forms (except HO-8)
• As an optional valuation method for commercial property

Functional Replacement Cost

Functional replacement cost values property at the cost necessary to replace damaged or destroyed property with new property of unlike kind and generally lower quality which perform the same general function yet allow the insured to accomplish its objectives. Property replaced using functionally equivalent materials and products are less expensive and often require a shorter replacement schedule. This valuation option may be appropriate:

• When the insured cannot rebuild the same square footage, usually due to the application of building codes, and a smaller building will be built in its place;
  
• When the insured does not want to rebuild the same square footage;
• When lower cost building materials can or should be used (i.e. masonry/non-combustible vs. fire resistive); or
• If the insured does not need all the functions available on a particular piece of machinery or equipment (they found a great bargain on a top-of-the-line model, but don't need or use all the functions available and the insured does not want to pay the premium to insure it for the cost new).

Functional replacement cost is found:

• As the valuation method applicable to Coverage A in the HO-8
  
• By endorsement to the commercial property policy

Market Value

There is one more “value" you will have to deal with, especially when dealing with NFIP's flood insurance coverage and ordinance or law coverage – “Market Value." Market value is what a willing buyer will pay a willing seller, which is generally not related to insurance. But, NFIP's manual rules applies market value as the basis for many of its rules.

Likewise, many jurisdictions apply market value as the basis to decide at what point a damaged building must be brought into compliance with local building codes.

Lastly, in some states, market value is considered equivalent to actual cash value. And in the states that apply the broad evidence rule, the structure's market value is one piece of “evidence" used to develop the actual cash value.

So, although we don't think of market value as an insurance value, this valuation method can play a role. Market value is part of and plays a role in:

• NFIP conditions
  
• The ACV calculation in some states

Let's End This

Even though a specific piece of property can have multiple values assigned to it, from an insurance perspective, only four matter. Property can be valued at its:

• Replacement cost;
  
• Actual cash value;
• Functional replacement cost; or
• Market value.

The value that applies following a loss is a function of the needs of the insured, the form and endorsements applied and the state. Our job is to meld all this information to develop the correct amount of coverage. And what we discover, this can be difficult.

For another VU article on property valuations, visit this link. 

Last Updated: February 10, 2025

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