How is commercial property insurance calculated?

The right commercial property insurance will help ensure your business bounces back in the event of an accident or a disaster. But with so many different policies and coverage types, it’s hard to determine which one will provide the right coverage for your business. Replacement Cost coverage and Actual Cash Value coverage are two types of commercial insurance that differ in how they calculate the value of property lost in an unforeseen event.

What is Replacement Cost in Commercial Insurance?

Replacement cost policies cover the cost to repair or replace a building with materials of the same or comparable quality. This type of coverage replaces and repairs items to their identical state, so it doesn’t include improvements required by building codes or laws passed since the building was built. It also doesn’t include the value of any land. It’s determined by the amount needed to hire contractors and purchase materials to repair or replace a building.

Theoretically, the replacement cost of a commercial property insurance policy should be lower than its market value. Replacement cost only has to account  for building materials and labor to determine compensation. However, the costs of material and labor can fluctuate. This makes it possible for the replacement cost of a property to be higher than its market value.

Replacement cost policies offer more financial protection in the event of a loss because they don’t take depreciation into account when determining compensations. However, this type of coverage is usually more expensive and may not be the best option for every property. Without continuous maintenance and renovations, the value of a building will generally depreciate over time. It may be better to opt for a less expensive policy that still protects the operations of your small business.

What Is Actual Cash Value in Commercial Insurance?

An actual cash value policy also covers the cost to replace or repair a property, but the rate of compensation accounts for the depreciated value of the original property. Commercial property covered under an actual cash value policy will be replaced or repaired using modern construction techniques and materials. Actual cash value policies generally have lower premiums than replacement cost policies and may make more sense for particular types of properties.

How Is Commercial Property Insurance Priced?

Replacement cost and actual cash value aim to make your business whole again after a loss. The difference lies in how the loss value is calculated. Here’s an example that highlights the difference between the two.

Calculating Actual Cash Value Policies

Suppose the owner of a cafe installed a large screen TV purchased for $1,000 four years ago. Then there was a theft, and the TV was stolen.

If the owner has an actual cash value policy:

The small business owner will receive the difference between $1,000 and the depreciation for the time he/she owned the TV. The insurance company determines the useful life of a TV is 10 years, so 10% depreciation would apply to the TV each year.

4 years x 10% per year = 40% depreciation

$1,000 x 40% = $400 depreciation

$1,000 – $400 = $600 actual cash value.

So the payment from the insurance company would be $600 minus any applicable deductibles.

Calculating Replacement Cost Policies

Now let’s consider that same example if the owner had a replacement cost policy.

The cafe owner would receive the total amount it would cost to buy the same (or a very similar) TV at a store today with a receipt. Using the same example from above, the insured would receive a check for $600 which is the actual cash value and – with a proof of purchase showing he’d bought the same or a very similar TV as a replacement – he would receive a second check for $400. Both checks total $1,000, or the replacement cost value. (The business owner would also factor in any applicable deductibles.)

What’s Right for Your Business?

When deciding between replacement cost coverage and actual cash value coverage for your commercial property insurance policy, it’s important to review the exclusions carefully. The exclusions will determine if additional policies are necessary to meet your business’s specific needs. Also, some business loans have requirements for the type of coverage the business must have. Be sure to check with your lender for these requirements.

The specific elements of your business will also help determine which policy is right for you. For example, a store located in a very old building in a popular urban environment will not depreciate as quickly as a new office building located in a business park. The store is more location-sensitive and doesn’t require a specific type of building to operate. Thus an actual cash value policy with lower premiums may make more financial sense than a replacement cost policy with higher premiums.

If you’re still unsure which type of commercial property insurance is right for your business, contact one of our agents at Wallace, Welch & Willingham. Our insurance experts will help you determine the right coverage for your business.

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