Not all Insurance Policies are Created Equal

This is not the time to be learning about your insurance limits.

I serve as property manager for my condo association. Lately our insurance for the property has gotten pretty expensive so I have been shopping for a new policy. I had the following interesting exchange with one of the insurance agents:

Me: Yes, I'm also a real estate blogger.
Agent: Oh wow! [Company name] doesn't let its sales agents have blogs, so could you please please do me a favor?
Me: Maybe...
Agent: Can you tell your readers about actual cash value vs full replacement cost? Please?

So hey, here we go.

Layers of Insurance

If you own a single family home in Illinois and have a mortgage you must carry homeowners insurance. If you pay cash you don't have to carry homeowners insurance but it's still a good idea to at least have some coverage. If you're in a condo, the insurance situation is far more layered.

It goes a little something like this.

Condo owners may not have to deal with shopping for the bigger, association-wide policies as I've had to do over the past two weeks but it's still worthwhile to know your coverage levels just in case. Beyond the face value of an insurance policy as a means of recovering from a disaster, a condo owner has a financial stake in the master policy too. Every condo buyer will need to obtain proof from the association that there is a building-wide master policy, so condo owners who are looking to sell should make sure that the policy remains in effect and provides sufficient coverage.

Regardless of if who you're shopping for, you need to know the difference between actual cash value and replacement cost value. The key factor here is depreciation.

Things Fall Apart. The Center Cannot Hold.

The whole point of insurance is to replace items that are damaged, destroyed or stolen. However, it's difficult to establish a value for those items when issuing an insurance policy. After all, the comparative value of things changes from year to year. Your old Playstation, Blackberry and 10 year old car are not worth the same now as they were when you purchased them. Your house is subject to value loss over time as well. Even if the sale price of the home itself increases, the actual value of the component parts - the windows, lumber, hardware and appliances - decreases as each part approaches the end of its maximum useful lifespan. This loss of value is called depreciation.

Depreciation is used both in calculating income taxes and insurance. When you file your income taxes you can claim this depreciation as a loss. This may mean that you pay lower taxes - an excellent scenario. However, when your insurance provider uses it, it allows them to pay you less for your damaged items. This is not so good.

Regardless, depreciation is useful only on paper. If your home is damaged it doesn't matter how much Blue Book value the old stuff lost over the span of years that you owned it. What matters is how much it's going to cost you to get new stuff. This is where the difference in policies comes into play.

The story of a sad fence.

An Actual Cash Value policy will pay out only what the lost items were worth, once depreciation is figured in. A Replacement Cost Value policy will pay out the full cost to get new items in the current market. Let's look at an example.

That'ssss a nice fence you have there...

My condo building is surrounded by a six foot tall wooden privacy fence. It was only meant to be a temporary installation by the developer until they finished construction, but the developer went bust. Six years later, the fence is in pretty sorry shape but it's better than nothing. (It's on the list for replacement next year.)

Let's say that one of the neighbors who use our parking lot to turn around in the alley were to get overly vigorous and back into our fence. I do not expect that it will simply fall over. Given its current condition it may well shatter into many small pieces. It would need to be replaced.

A new wood fence would cost us about $1500. However, our existing fence is at least half way through the expected 10-12 year life span of a wooden fence. The most I could hope to obtain from an Actual Cash Value policy would be about $750. A Replacement Cost Value policy would answer the claim with a nice $1500 check.

Special Considerations

Buildings marked for preservation and homes full of antiques require different insurance policies. Many of them have past the point of depreciation and are now increasing in value due to their architectural importance or historic value. They can be restored, but restoration costs are far more expensive than you'd see on a standard house. If fully destroyed you cannot replace it with a new building of equal value. If you're in possession of items for which time is running widdershins you will want to discuss all of your options with your insurer to make sure that your policy is giving you proper coverage outside of standard depreciation rates.

Obtaining the restoration permit alone can be more expensive than you might think.

Replacing damaged property gets more expensive when you're forced to follow local laws. There's a lot of ways that I can knock down a building so that I can start over and rebuild. However, around here I can't just go Incredible Hulk on the structure and then dump the leftovers into the river. I have to make sure that I'm not killing any wildlife and that the replacement building is assembled by reputable people with permits & licenses. Building Ordinance and Law coverage will be a line item in most homeowner and condo association insurance policies and accounts for the difference in cost.

There's one other major issue when it comes to Illinois laws. Actual Cash Value policies are illegal for condo associations per the Illinois Condominium Property act. Check it out:

Section 12(a) Required coverage. No policy of insurance shall be issued or delivered to a condominium association, and no policy of insurance issued to a condominium association shall be renewed, unless the insurance coverage under the policy includes the following:

(1) Property insurance. Property insurance (i) on the common elements and the units, including the limited common elements and except as otherwise determined by the board of managers, the bare walls, floors, and ceilings of the unit, (ii) providing coverage for special form causes of loss, and (iii) in a total amount of not less than the full insurable replacement cost of the insured property, less deductibles, but including coverage for the increased costs of construction due to building code requirements, at the time the insurance is purchased and at each renewal date.

So while single family home owners have the discretion to go with an Actual Cash Value policy and save a few bucks in premiums by doing so, a condo building will not have that option. It has to full replacement cost, it has to include ordinance and law coverage, and the amount of coverage has to be updated every time the policy renews. To prevent the riskiest buildings from falling through the cracks, Illinois has a backup option called FAIR which offers coverage to homeowners and HOAs that cannot get insurance in any other way.

For those of you who are worried about the government forcing us to buy health insurance, I hope you understand the implications of this bit of law.

I'll definitely revisit this topic later, so if you have questions please let me know!