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Insuring a $25 Million Building for $1 Million: E&O Waiting to Happen?

A prospect bought a warehouse for $1 million. The replacement cost is $25 million but the owner only wants to protect their investment and has said they wouldn't replace the building in the event of a total loss.
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A prospect owns a warehouse and rents it out to a manufacturing business. The building replacement cost would be roughly $25 million, but the owner only bought it for $1 million.

The owner has expressed to us that they do not want to insure it for the replacement cost value, and are only looking at protecting their investment.

They also told us they would not replace the building in the event of a total loss. My initial reaction is that they won't be able to insure the property for anything less than actual cash value (ACV).

Q. Have you ever encountered a client not wanting to insure the building for the replacement cost value? Is there any type of agreed value option?

Response 1: I have come across several property owners with this attitude. I’ve found that, in virtually every case, these property owners are thinking only in terms of insuring against a total loss to their property. However, the overwhelming percentage of property losses are partial losses. These partial losses include commonplace events as a roof collapse due to buildup of ice and snow, a fire in a small percentage of the structure, frozen plumbing or vandalism.

I’ve personally had success explaining the chance of a total loss compared to the chance of a partial loss and trying to influence the prospect to assume a more realistic position. I couple that explanation with a little primer on how coinsurance operates in property insurance—most people assume property insurance coinsurance operates like medical insurance coinsurance. 

In effect, a property owner with a $25 million building who wishes to insure it at a $1 million limit has made a decision to assume a $24 million deductible or retention, not realizing he is assuming retention at the opposite end of the property loss spectrum from where most planned retentions exist. Overall, it’s a questionable risk management decision. 

Encourage recalcitrant property owners to insure to at least 80% of ACV but to assume an extremely high deductible. This is after I’ve made the point about the relative rarity of total losses, of course. I emphasize the certainty of the higher deductible, contrasting that with the total uncertainty of retaining the difference between the building’s ACV or replacement cost and the amount of insurance they wish to buy.

If none of this works, I recommend walking away. This prospect’s attitude toward risk and insurance is not at all encouraging and will very likely lead to problems when losses do occur. 

Response 2: An errors & omissions defense attorney I work with has a saying about customers like this: “That’s a customer not worth having.” Even with documentation, when the values get that high, a plaintiff firm will likely be willing to roll the dice and pursue the agency.

Response 3: I’ve had clients who requested something similar and researched a variety of ways to meet their requests. I found no insurer willing to insure only the client's equity. No experienced underwriter is willing to insure a $25 million building for $1 million. Even on an ACV basis, it likely to be underinsured. 

It is unlikely, but perhaps through excess & surplus lines insurers you could arrange a demolition-only policy that would apply if the damage is in excess of a certain percentage—say 50%. If the damage is less than the stated percentage, the insured would be on his own to repair the property or demolish and clear the debris.

Response 4: Have you explored the possibility of a functional replacement cost endorsement? Or, run a coinsurance example to show how picking a limit would penalize them for all partial losses. Also, see if an insurer will offer a flat rate or limit option, but I feel that they will not be happy when they find out what flat rate options will actually cost.

Response 5: You might be able to insure it on a market value basis. You have to submit a statement of values for agreed value, but I’d be surprised if an underwriter would accept such a discrepancy. Use caution in this situation because the insured will want replacement cost at the time of a loss and will say that you didn’t explain the coverage to him. I worked on an E&O case where that was exactly what happened. 

Response 6: I have encountered these situations repeatedly. An insured acquires a large, typically older building, for a fraction of the replacement cost and wants to insure the property for their "functional" value. A number of these properties subsequently experienced substantial losses, none of which were suspicious. The mortgagee immediately took the sum of any outstanding debt from the insurance proceeds. The insured was typically left with a modest amount of cash and huge uninsured bills to either repair or demolish the buildings. 

You can insure the property on a functional replacement cost basis, but include adequate limits for ordinance or law exposures with substantial increased debris removal coverage. Otherwise, walk away.

This question was originally submitted by an agent through the Big “I” Virtual University’s (VU) Ask an Expert Service, with responses curated from multiple VU faculty members. Answers to other coverage questions are available on the VU website. If you need help accessing the website, request login information.

Tuesday, June 2, 2020
E&O Loss Control