What is Replacement Cost?

Every good insurance professional strives to convince clients to insure their homes and buildings to full replacement cost unless extenuating circumstances exist. They do this because full replacement cost is the best method for protecting clients. If their home or commercial building is lost and they have full replacement cost, they can rebuild their buildings and lives much more quickly, with much less stress. A professional insurance agent’s goal is to provide the best coverage for the worst event.

Losing a home or commercial building only to learn that you are underinsured and you cannot rebuild without taking on a new mortgage, while still having to pay off the old mortgage or having to take out retirement savings, can be financially and emotionally devastating. According to several estimates, a large percentage of properties are materially underinsured.

Underinsuring property does not benefit the agent. Underinsuring property means lower commissions for the same amount of work and a higher probability of being sued. It makes no sense to underinsure property unless you are one of those agents who underinsure so that you can trick a client into thinking they’re saving money. And I’ve been writing long enough to know some readers who don’t think this happens purposely. Not only does it happen, some carriers have been known to train agents to sell like this. They should lose their license. Period.

Carriers should not want to underinsure because they lose premiums for only a partially reduced exposure profile. They risk brand injury when claims are not paid. And they make more work for their agents. Two exceptions exist here. The first is they have nothing to sell but price, so they encourage reducing coverage to pretend their rate is better. The second is some carriers likely have a TIV issue overall or in certain geographic areas.

Another reason is less purposeful, and that is through incompetence and ignorance. This begins with replacement cost estimators. The margin of error on these is so high that, at best, the results should be considered ballpark, and the ballpark is the size of several baseball fields. Back when replacement cost was first calculated, carriers recognized that, lacking data and technology, the error rate would be high, so they began offering guaranteed replacement cost. Initially, many of these endorsements were unlimited and not heavily dependent on a precise replacement cost calculation. Over time, though, most carriers began stipulating that for the guaranteed replacement cost coverage to be triggered, the building had to be insured within X% of the replacement cost at the time of the claim, and furthermore, the guaranty was only good for Y% more than the stated coverage amount. If the estimators were better, these limitations would not be an issue, but the estimators are not better.

The high error rate is due to many factors, often all playing a part:

User error. The providers of these estimators need to provide considerably more training on how to use them, and the users need to better articulate to clients how to describe their building, better measures, and so forth. Several years ago, I tested my own home. The variance was almost 75%, depending on the estimator used and the agent using the estimator. That variance is so high it’s worthless.

A good place to begin is with quality definitions, maybe even standardize the definitions. What is a normal cabinet versus a custom cabinet? If I go to a big box store, cabinets are all pretty normal to me, not custom in any way, and yet the price differs significantly. The same goes for trim, appliances, and even paint. I can increase the replacement cost of a house by at least 25% on this basis alone.

Carriers insisting on fantasy values. I don’t know where some carriers are getting their estimates. I saw an estimator for Hawaii that, by square foot, was the same replacement cost as Arizona. It is as if the carrier never looked at a map to learn that around 90% of the materials must be shipped to Hawaii, and container ships are not free. Completely inexplicable.

This is an easy example for everyone to comprehend. This happens a lot in the real world, not just in Alaska and Hawaii. I want to believe carriers are just far behind times, and their obstinate refusal to insure to value is not because they have a TIV issue they don’t want to admit. The first step to recovery is admitting you have a problem.

Improved Terminology. With such high error rates, carriers and regulators should consider better terminology to suggest that replacement cost is a good faith guess. Doing so might minimize disappointment upon learning a home is not insured to value post fire.

Furthermore, a huge portion of homes and commercial properties today are not insured to true replacement cost because the standard policy does not include adequate ordinance coverage. Suppose a home is lucky enough to be insured to value and the guaranteed replacement cost endorsement kicks in, but then major upgrades are required to meet ordinance requirements. In that case, the insured will unhappily discover they’re still materially underinsured. Replacement cost only applies to how it was, not how it must be. Real world matters.

Better terminology would help everyone understand what is being insured, so consumers would be less likely to think they have adequate coverage when they probably don’t.

Now, for the egregiously wrong part of replacement cost: Some carriers are effectively doing a bait and switch. In a March 30, 2025 blog by Chip Merlin of Merlin Law (I highly recommend subscribing), he wrote about a recent court ruling that allowed a carrier to use software to calculate the cost of rebuilding. One problem is that this software is not the same software used to calculate replacement cost in the first place. That makes no good sense.

But worse, the software, by everyone’s agreement apparently, calculates replacement cost as if all rebuilds were new construction even if it was restoration/remodel, i.e., a partial loss. Restoration often costs materially more than new construction, so why would a carrier be allowed to only pay for the claim based on a “new” construction estimate versus the reality of a restoration estimate?

The carrier in the case said its policies do not require the carrier “to use any specific estimating methodology.” I guess they put a thumb in the air then. I have never worked with this carrier or had clients who did, so I do not know how they manage their replacement cost estimators upon application. But many policies do not define adjusting methodology.

This is a bait and switch. If a method must be used to calculate replacement cost, the same method should be used to calculate the claim. And if the numbers are low even on a new construction basis, then know that replacement cost will be especially low on a partial loss, which increases the need to increase coverage values.

This thought process begs bad publicity, bad faith, and more litigation. Pinching dimes to save pennies makes no sense. I wonder if the added litigation costs are being compared to the savings from clients who don’t sue?

This particular carrier’s five-year homeowners loss ratio is so bad, they may be getting desperate if I’m guessing correctly. But a loss ratio that high suggests a better solution exists, including smarter underwriting management and maybe doing a better job calculating replacement costs upfront (more premium and about the same losses) versus using what I consider inappropriate claims calculating software.

Professional agents can help protect clients by learning the ins and outs of replacement cost estimators and policy provisions. Then, ask the questions this legal case poses: “What method do you, the carrier, use to settle property claims? Do you use the same calculation method to settle a claim as you do to estimate the original replacement cost? How about partial claims?”

And better yet, fire the carriers that play these games. Don’t write with them.

Fair, ethical claims adjusting pays dividends, including maybe elevating an awful reputation to a slightly less awful reputation. Nothing good comes from the lack of transparency in these situations unless a person/company has something to hide and then gets away with hiding it. If a carrier says their rates are based on this trickery, we are just back to the carriers who might still be teaching agents to sell inadequate coverage and pretending it is adequate, but cheaper.

---

NOTE: The information provided herein is intended for educational and informational purposes only and it represents only the views of the authors. It is not a recommendation that a particular course of action be followed. Burand Insurance Education, Burand & Associates, LLC and Chris Burand assume, and will have, no responsibility for liability or damage which may result from the use of any of this information.

None of the materials in this article should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this article. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules, and regulations.