Question on Extra Cost of Reinstatement received a phone call from Brett (surname and email provided) seeking clarification on the best way to treat Extra Cost of Reinstatement. The client was questioning why there needed to be a sub-limit when the property valuer they had engaged, had already included an allowance in their valuation and this was used to set the Declared Value on the building.

My response was that, regardless of the basis of valuation, the Insurer and their loss adjuster would calculate a claim under the terms and conditions of the Policy, in this case, the Australian Mark IV Industrial Special Risks Policy.

Under the Basis of Settlement section, the Insurer would in the first instance base the settlement on the current Reinstatement and Replacement value of the building, machinery and plant and other Insured Property other than the property specifically listed, that is:

b)       Raw Materials Supplies and Other Merchandise not Manufactured by the Insured

c)       Material in Process

d)      Finished Goods

e)      Rewriting of Records

f)       Patterns, Models, Moulds, etc

g)      Glass

h)      Directors’ & Employees’ Clothing & Tools of Trade

i)        Empty Premises Awaiting Demolition

No allowance for Extra Cost of Reinstatement would be taken into account at this stage.

The figure for the Reinstatement and Replacement once agreed, would be subject to the Provisions of the Reinstatement and Replacement Memorandum, such as the requirement that the Insured actually incur the cost. Another important test is Proviso 3, the test for under-insurance which is known as the test for coinsurance.

The Insured is then entitled to claim for the Extra Cost of Reinstatement to bring the building up to the current requirements of any Government or Statutory Authority. This cost is limited to any Sub-Limit of Liability for Extra Cost of Reinstatement and the overall Limit of Liability of the Policy but is NOT subject to a Co-Insurance Test.

There is an important proviso, Proviso iv of the Extra Cost of Reinstatement Proviso that states:

(iv)      If the cost of reinstatement of damaged property insured is less than fifty per cent (50%) of that which would have been the cost of reinstatement if such property had been destroyed, the amount recoverable hereunder shall be limited to:

(a)       the extra cost necessarily incurred In reinstating only that portion damaged; or

(b)       whilst applying to such property insured, the Sub-Limit stated herein,

whichever is the greater. In the event of a Sub-Limit not being stated in this Policy the Insurers liability shall be limited to the amount as described in sub-paragraph (a) of this provision.” [emphasis mine]

The key is the word ‘greater’: it is not the ‘lessor’!  This means that if the Insured elects to take a Sub-Limit of Liability for Extra Cost of Reinstatement, then they are entitled to claim up to the Sub-Limit of Liability to have the entire building and contents (excluding stock) comply, rather than just that portion of the building that was damaged. This is an extremely important benefit that the drafters of the wording who clearly had a social conscience and wanted their clients to be fully protected in the event of a loss.

So how do you best protect the client under these circumstances under a Mark IV or Mark V ISR policy?

1) To the best of your ability ensure that the valuation is adequate. Was it prepared for insurance purposes or for financing or other  motives?

2. If you are satisfied the valuations are accurate at the state of period of insurance and include an Extra Cost of Reinstatement component, strip the Extra Cost Component out of the total valuation and Declare the Buildings at their Reinstatement and Replacement value only (with a fair allowance for architects, engineers fees etc in accordance with the Policy requirements), but with no allowance for Extra Cost of Reinstatement.

3. Select an adequate Sub-Limit for Extra Cost of Reinstatement to bring the existing building up to code etc.

Screen shot of LMI RiskCoach showing the location of the ISR Limit of Liability calculator

Screen shot of LMI RiskCoach showing the location of the ISR Limit of Liability calculator

4. Select an overall Limit of Liability, which will protect the Insured eg it includes the total of the Declared Assets at the Target (largest risk location [Section 1] only at this stage) plus the major Sub-Limits of Removal of Debris, Extra Cost of Reinstatement and Additional Extra Cost Reinstatement, and any other major additional benefits you have included in the coverage that is payable over and above the Declared Values PLUS an allowance for reasonable cost of inflation, cost in the Property Insured at the start date of the Period of Insurance and the reasonable period the assets were replaced should a loss occur on the last day of the Period of Insurance. I use 20% as a rule of thumb.  [I have designed and built a ISR Limit of Liability Calculator for both Section 1 and Section 2 which is available as part of LMI RiskCoach]

Like many things in life, there are more ways than one to achieve the desired result. Another is to leave the valuer’s estimate in the Declared Value and delete Proviso 4 from the Extra Cost of Reinstatement Memorandum.

Being a purist, I prefer my first method.

Brett, I am glad you took the time to ring and seek advice to ensure that your client is protected and your Professional Indemnity program is not exposed. I can see how someone could be easily misguided by relying on the valuer’s valuation and the client being penalised for not dissecting the valuation and setting the Declared Values, Sub-Limit and all important Limit of Liability in accordance with the design of the Policy.

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