Pub. 4 2014-2015 Issue 1

18 O V E R A C E N T U R Y : B U I L D I N G B E T T E R B A N K S - H E L P I N G C O L O R A D A N S R E A L I Z E D R E A M S This requires preparation. After a loss, whether it is one home or a wide-spread disaster, correct replacement values can make the difference between restoring a home and its belongings rela- tively quickly and without surprises, or leaving it under dark, foreboding skies for a while. There have been recent changes in flood insurance rules and rates. Most flood damage is not covered by private insurance. It is within the purview of the National Flood Insurance Program and the public has been learning about (and reacting to) the ef- fects of new flood zones and rate hikes for flood insurance as part of the Biggert-Waters Act. Banks have also received additional regulations about property and flood insurance on mortgaged structures. Regardless of one’s opinion about the new zones, rates, NFIP, and the impact of these changes, the sunny days and the aftereffects of storms can be impacted by the simple question: “What is the house’s replacement cost value?” For 26 years I have been helping to answer that question. Over those 26 years the number of related questions has not diminished—they have increased. Homes have market, mort - gage, tax assessed, depreciated, income, cost, sales, replacement cost values and more. How can the correct replacement cost value be determined? What factors influence this value? What does replacement cost include? Can a risk manager manage the bank’s risk without knowing the answers? Can a planner plan adequately without knowing the answers? The impact of an incorrect value has also increased. There are issues for all involved parties when the insured value is less than what it will cost to actually rebuild the structure. The further apart the insurance limit is from the actual replacement cost, the worse off all involved parties are. For homeowners, it could mean that they are not able to rebuild what they’d had. It could mean they might only be able to build back a lesser house, or no house, or need to pay a large sum above the insurance payment to rebuild the same house. Their contents coverage, which was based on a Coverage A amount that was too-low, might not be sufficient to replace the contents that they lost. For REO prop - erties underinsurance can mean a decline in asset value. The amount of flood insurance needed is based on the replacement cost value. If one is incorrect, both are incorrect. However it’s not just major disasters that affect homeowners. Since the majority of claims are not post-disaster, most are not even for complete replacement—they are for partial losses— underinsurance could mean greater, unexpected payments by homeowners for covered losses. This additional financial stress on homeowners is avoidable by properly developing the replace- ment cost. What is replacement cost? The basic definition of Replace - ment Cost is the cost to replace an asset in today’s market. For a home, it is generally defined by an insurance contract with the modifier of “like kind and quality.” That’s only four words, but those four have a great deal of impact. The value developed by market value approaches that use the cost approach will result in the replacement cost minus depreciation, which makes the end result an “Actual Cash Value.” There is often a misunderstanding of the difference between market value and replacement cost. Market Value is the value that comparable homes are sold for or what a buyer is likely to pay to purchase a particular property. Replacement Cost is what it will cost to rebuild the home with materials of like or similar quality, in the shortest amount of time and with a builder who is basically building the home as a custom-built house. Even though market values declined dramatically in recent years and inmanymarkets there is an abundant supply of homes for sale at discounted prices, this is not relevant to the cost to replace the home should a loss occur. The factors that affect rebuilding costs have generally risen over the last few years. Most factors that influence a home’s replacement cost are outside of anyone’s control. Worse, after a disaster, the costs can be additionally impacted as the result of a large number of homes being rebuilt at the same time. Some of the replacement cost factors are material prices, labor costs and availability of builders. Material prices can be affected by global supply and demand, in addition to local and national con- ditions. As for the availability of builders, the market supply has tightened and there are fewer contractors and sub-contractors than there were a few years ago. Many of the skilled construction workers left the field when the work dried up during the reces - sion and replacing them has been a slow process as demand for houses has increased. Other factors that affect a home’s replacement cost are that there are no economies of scale for the rebuilding of a single home and time is of the essence when a total loss has occurred. There is pressure to rebuild quickly. With rebuilding, the previous structuremust be removed compared to new construction, which starts building on an empty lot. These factors result in greater expensive for rebuilding an already existing home compared to new construction of a home. Underestimating the influence of the four words, “like kind and quality,” could affect a large percentage of a house’s replace- ment cost value. If the initial value is not right, then the actual cash value is wrong, as well. These words are oftenmentioned by FEMA/NFIP programs, but usually quickly and without much guidance concerning their impact.  Replacement Cost – continued