Author: VU Faculty

Our "Ask an Expert" service received a question recently from an agent who represents an insurer who has begun using a Functional Replacement Cost Loss Settlement endorsement on older homes that have construction materials that are obsolete, antique, or custom. This endorsement says that in the event of a claim, the damaged building will be repaired or replaced with less costly common construction materials and methods. The big issue is how to arrive at the Functional Replacement Cost limit.

"One of my companies is starting to use the Functional Replacement Cost (FRC) Loss Settlement on older homes which have construction materials that are obsolete, antique or custom. This endorsement says that in the event of a claim, the damaged building will be repaired or replaced with less costly common construction materials and methods.

"I understand this. What I don't understand is how to arrive at the Functional Replacement Cost limit. We have replacement cost programs using the RCT program, Boeckh guides, etc. for figuring replacement coverage on the dwelling. But when figuring Functional Replacement Cost, is there a certain percentage of this RC figure that should be used?

"One of the company underwriters advised our office that as long as the dwelling is insured to at least 50% of the replacement cost, and the policy was endorsed with the Functional Replacement Cost Loss Settlement Endorsement, there would be no coinsurance penalty.

"If you can help explain how to figure the amount of coverage on the dwelling when using this endorsement, it would be appreciated. Thank you!"

Functional replacement cost has been around for many years in commercial lines, but we're just now seeing it in a similar format in personal lines. ISO has addressed this problem historically with the HO-8 form that provides ACV or market value coverage. Below are some comments and caveats from the VU faculty on this issue.

There is no way to reliably or accurately arrive at such an estimate in my view.  How do we know what type of materials will be used for replacement? And, to say to write it for at least 50% of the RC to avoid a coinsurance penalty is a problem....the HO policy does have a coinsurance feature, but it never pays less than ACV. Is the underwriter's claim of "no penalty" specified in the policy? Do you have it in writing?

I'd err on the side of caution and insure for the full replacement cost. Better to have too much coverage as opposed to not enough.

I have used FRC for thirty years and will suggest you be very, very careful. The limits should be a joint decision between the agent and insured after careful consideration of the impact. Also, address the issue of debris removal for the larger, older structures. 

A large loss on an older structure has surprises for everyone.

As for the suggestion to use regular replacement cost, this might be a problem if they expect replacement with out of style/unavailable items such as hand-made wrought iron, etc. The ISO Commercial Property Rule 38 has an example of how to compute the amount of insurance needed, but it probably doesn't have much applicability to a home.

Regarding the underwriter's suggestion of using 50% RC minimum, I would sure want this in writing! Any guidance in the company's manual?

I would be VERY suspect of a blanket statement that 50% of RC would be appropriate. If we're talking about larger, older homes with heavy timber construction, ornate cornices, solid brick exterior walls, wood lath and plaster interior walls, etc., yes, it can be very expensive to insure on a RC basis. However, I think it is easy to UNDERestimate the loss even on a functional RC basis.

With older homes, you can have significantly higher debris removal costs (including asbestos abatement and disposal expenses) and ordinance or law exposures can be substantial for electrical, plumbing, and even thoroughfare offsets. When all is said and done, the total amount of insurance even on a functional RC basis (considering debris removal and O&L coverage) may be the same or even more than pure RC, so the 50% figure is odd to me.

I would ask the insured to give the agent an amount they estimate it would take to rebuild the home with materials that are functionally equivalent. This would need to be obtained from a contractor or architect. Also they need to look at HO 05 31, it appears to be a little broader after loss than HO 05 30. A valued policy law could apply, depending on state law in N.D.

This is the first time I've seen functional replacement cost used on an HO policy. I have no idea how to come up with a limit because it depends on what structural features have functional replacments. Also, I wonder how this might be affected by valued policy laws. This is the company's form...make them come up with a reliable way to ensure an adequate limit.

Be very careful...here's a good reason why:

Shah v. Allstate Ins. Co.

(filed September 12, 2005; ordered published October 31, 2005)

2005 Wash. App. LEXIS 2385

The plaintiffs bought property, obtained a loan to pay for the property, and then obtained insurance on the property from their insurance agent, with whom they had a long-standing relationship. The property burned down several years later, and although the plaintiffs were paid the limit of the policy, replacement of the home would have cost significantly more. The plaintiffs brought an action against the insurer and the agent, claiming that the agent was negligent because he underinsured the property, relied on incorrect information when creating the policy, and did not inform the plaintiffs of possible uninsured exposures.

The plaintiffs also claimed that the agent negligently misrepresented to them that the policy was a replacement value policy, and that he violated the Consumer Protection Act. The trial court granted summary judgment to the insurer and agent, finding as a matter of law that, since the plaintiffs knew the policy value limit and had real estate knowledge, they did not rely on the agent with respect to the negligent misrepresentation claim. The trial court also found that, as to the other tort claims, there was no demonstration of a proximate cause because of the intervening judgment and business decision of the plaintiffs.

The Court of Appeal reverses the summary judgment. The negligence claims were improperly dismissed because there are genuine issues of material fact as to whether the plaintiffs actually knew that they had inadequate coverage; whether the plaintiffs made a conscious choice to keep their coverage low; whether the agent was negligent in failing to follow the plaintiffs’ instructions to meet the lender’s minimum requirements; whether the agent’s use of allegedly incorrect property information and his failure to verify this information was negligent; whether the agent was negligent in failing to advise the plaintiffs that they had inadequate coverage; and whether the agent’s failure to understand and explain how the insurer’s cost estimator computer program worked was negligent.

The negligent misrepresentation claim was improperly dismissed because there is a genuine issue of material facts as to whether the plaintiffs were justified in relying on the agent’s statement that the policy was a replacement value policy. The Consumer Protection Act (CPA) claim was improperly dismissed because there are genuine issues of material fact as to whether the agent’s actions violated the CPA.

For more on the various types of property loss settlement clauses, visit this link. 

Updated: March 25, 2025

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