Replacement Cost Coverage is Not Your Friend

Some Advice for Business Owners with Commercial Insurance Policies

Every business that owns or operates out of a brick and mortar location needs a commercial insurance policy for that building. This we can all agree on. But what happens when the insurance policy will pay out only after the policy holder replaces the destroyed property? What happens if the insurance company (surprise, surprise) decides it may not pay at all, based on policy exclusions?

As a business owner, you can be left high and dry if you don’t have the capital to pay for the replacement up front. It is well worth the time it takes to make sure your policy actually protects you against loss on the front end.

Virginia commercial insurance policies can feature several different loss payment provisions that dictate the amount the insurance company will pay upon loss, and when they must pay it. What many Virginia business owners don’t know is that their commercial policy may not ever pay out until they replace their building and actually pay out for the replacement.

This is a problem that occurs with policies featuring “replacement cost” provisions, and their effect can be devastating if the business does not have the operating capital to fund a rebuilding project.

Replacement cost provisions may include language like this, and promise to pay you:

It’s all so clear now…or not. What exactly does this language mean?

It means that if the insurance company wants to it can force you to replace the building and pay for all that cost up front, before the insurance company will reimburse you under the policy (this provision often comes accompanied by another that allows settlement with the insurance company for actual cost value of the property in order to finance the replacement, and a supplemental replacement cost settlement 180 days later). This type of provision is acceptable under Virginia law, and it can have devastating effects on your business if things turn in a bad direction.

Let’s look at an example: a fire starts up in your building and burns the place down. The fire department thinks the fire may have started in the office kitchen, but it’s not clear whether it was caused by human error or electrical malfunction.

You have a policy featuring “replacement cost” loss payment, which means that the insurance company can delay paying you until you actually replace the building. The insurance company issues a reservation of rights letter, taking the position that because the fire might have been caused by electrical problems, the insurance company may not ever need to pay out on the policy (due to an exclusion that says the insurance company doesn’t need to pay for fires caused by electrical malfunction).

So, the insurance company is telling you that (1) you can’t get coverage payments until you actually replace the building, and (2) the insurance company may not ever repay those expenditures, depending on what it decides caused the fire. This is the perfect storm of replacement cost policies. What will you do? Pray that you have enough working capital to replace the building? Take out a loan on the replacement without knowing whether the insurance company will ever pay out? This dilemma can be compounded if the policy requires that you undertake to replace the building within a certain amount of time in order to receive coverage.

This may seem like it wouldn’t happen to your business—but it has happened, and the Virginia Supreme Court has ruled that the insurance company can do all of these things. In Whitmer v. Graphic Arts Mutual Company, the insurance company denied coverage, claiming that the owner of the burned-out building started the fire by arson. The policy featured replacement cost coverage, and required that the owner replace the building within a certain amount of time in order to get replacement cost.

The Supreme Court found that the building owner was not entitled to replacement cost, because he had not undertaken to replace the building in time, even though the insurance company was totally wrong about its claim that the owner committed arson. As a result of Whitmer, an insurance company may wrongly deny coverage, be proven wrong in court, but still not ever have to pay because the insured didn’t replace the building in time under the policy.

This is not just a 1990s thing, either. Recent cases confirm Whitmer is alive and well in Virginia. Examples? Vaughan v. First Liberty Ins. Corp., 2009 U.S. Dist. LEXIS 108045 (E.D. Va. Nov. 13, 2009) and Breton, LLC v. Graphic Arts Mut. Ins. Co., 2010 U.S. Dist. LEXIS 16274 (E.D. Va. Feb. 24, 2010) are just two.

So, don’t let this happen to you. Following are a couple of tips on how to protect yourself—now—against this perfect storm.

Look over your policy.

Take the insurance policy out of the dusty cabinet folder it has probably been sitting in since the day you got it, get a cup of coffee, and look through that policy. Does the policy have “replacement cost” coverage? You may want a lawyer to do this for you—it won’t be too expensive and shouldn’t take that much of your lawyer’s time to do.

Does the policy have replacement cost coverage? Negotiate out of it.

If the policy does have replacement cost coverage, call your insurance representative and tell him or her you don’t want replacement cost coverage. You can always negotiate, and it is worth doing this now, so that when disaster hits you won’t have a huge rebuilding project with no insurance funds to pay for it.