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By Kristin Suga Heres
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A wildfire ravages a community. A family’s home is among those destroyed. It is a total loss. The homeowners are eager to rebuild and turn to their homeowners’ policy. Having purchased coverage on a “replacement-cost” basis, they assume they are protected. They soon discover, however, that their policy limits are insufficient to satisfy their actual rebuilding costs, replace their personal property and meet additional living expenses. They are underinsured.

Unfortunately, this is a scenario that plays out time and again, particularly in the context of wide-scale catastrophe losses (e.g., hurricanes, floods, wildfires, etc.,) and single-risk total losses (e.g., a particularly destructive single-home fire). In 2013, one insurance industry consultant estimated that 60 percent of homes in the U.S. were undervalued by an average of 17 percent.[1] These numbers, while alarming, actually signify an incremental improvement over the previous year, and a very substantial improvement since the 1990s. However, significant room for further improvement remains, and the stakes are high.

Why are so Many Homes Underinsured?

While it easy to point the finger of blame at insurers, agents and brokers when premium paying homeowners come up short after a devastating property loss, underinsurance is a complex problem that often begins with using an improper basis for the amount of insurance limit purchased. Real property is generally insured at replacement cost value. Therefore, to ensure that property is sufficiently insured, the actual, current 100 percent RCV must be used as the basis for selecting the limit of coverage to be purchased. However, rather than using a property’s current 100 percent RCV, the amount of the mortgage remaining on a property or its acquisition cost, are sometimes used, to the insured’s detriment in the event of a catastrophic loss. It is easy to see how using these less-than-full replacement values, which seem like an attractive option for insureds looking to save a few dollars on insurance premiums, can leave homeowners without sufficient resources to undertake a complete, like-kind replacement. For instance, a homeowner who insures her home for the value remaining on her mortgage (e.g., $150,000) could face financially crippling out-of-pocket costs if it takes $250,000 to rebuild her home.

Insureds may also fail to appreciate and account for market forces that operate in a post-catastrophe environment. Demand surge for labor and materials, paired with strained supply following a catastrophe loss, drive skyward the costs to repair or replace property. Relatedly, the extended time it may take to make repairs or complete a property replacement following a catastrophe puts pressure on additional living expenses or business interruption coverage limits (in the case of commercial insureds), and policyholders may face cash constraints before the repairs or replacement are complete. Additionally, costly code improvements (e.g., raising the elevation of a flood damaged home) may further drive up repair/replacement costs versus the policy limits purchased.

Because catastrophe losses are more likely to be total losses (as opposed to partial losses), underinsured homeowners and businesses may also face coinsurance penalties. Coinsurance formulas used to calculate loss payments take into account the amount of insurance actually purchased and compare it with the amount that should have been purchased. The larger the discrepancy is between the amount of coverage purchased and the amount of insurance that should have been purchased, the smaller the loss payment amount will be.

Is Regulation the Answer?

The insurance industry has taken a number of steps to address the underinsurance issue, including introducing policies that offer “extended replacement” coverage. These types of policies pay up to a specified percentage above the policy limit in order to account for post-catastrophe demand surges and other unforeseen costs. However, by themselves, these measures have clearly not solved the underinsurance problem entirely. Further, while insureds can take steps to reduce their risk of being underinsured, including regularly reviewing and updating policies to reflect the actual replacement cost values, it is unrealistic to expect that all homeowners will invest the time and effort required to do so. In recent years, some states, including California, have therefore turned to regulation as a way of curbing the catastrophic consequences of underinsurance.

After years of wildfire losses drove the underinsurance problem to the surface in California, insurance regulators adopted a series of regulations aimed at improving the quality of replacement cost estimates for homes. As the California Department of Insurance explained in a Nov. 20, 2012, memorandum submitted in connection with a public hearing on catastrophic claims before the National Association of Insurance Commissioners:

In 2011, CDI adopted regulations that provide more comprehensive and reliable estimates of what it might cost to completely rebuild a destroyed home. Such estimates were previously unregulated, and led homeowners to believe they needed less coverage than they truly did in the event of a disaster.

The 2011 regulations placed a number of new requirements on California insurers and producers. Specifically, they mandated standards and training for insurance brokers and agents with respect to estimating replacement cost value and required improved documentation of persons making replacement cost estimates. The most extensive change, however, came with the introduction of standards for estimates of replacement value, which were codified within the subchapter of the California Code addressing “Unfair or Deceptive Acts or Practices in the Business of Insurance.”[2] Among other things, the regulation requires those estimating replacement cost values to consider specific features of the insured structure, including the types of materials used and the “[g]eographic location of the property.” It also prescribes detailed procedures for communicating replacement cost estimates to insureds and insurance applicants.

Not everyone, however, has embraced California’s efforts to solve the underinsurance problem through regulation. In fact, the insurance industry has mounted a fierce legal challenge to Section 2695.183, the meatiest of the regulations adopted in 2011. The Association of California Insurance Companies sued the Commissioner of the CDI, seeking that the court declare the regulation invalid. In the litigation, the ACIC argued that the commissioner lacked the requisite authority to promulgate a regulation that defines a new unfair practice under the Unfair Insurance Practice Act by mandating how insurance licensees produce and provide replacement cost estimates to homeowners. They also contended that the regulation infringed on insurance licensees’ commercial speech rights. On March 25, 2013, a California trial court sided with the ACIC and declared the regulation invalid, reasoning that the commissioner had indeed exceeded his authority. Because the case is currently on appeal to the California Court of Appeal, the future of Section 2695.183 remains uncertain.

While Section 2695.183 was invalidated on technical, legal grounds, the insurance industry’s real issues with the regulation appear to be its rigidity and its potential to interfere with the underwriting process. In the event that the commissioner loses the pending appeal, California will be forced to return to the drawing board.

Where do we go from Here?

While California has encountered significant difficulty in its attempt to address the underinsurance problem through regulation, that does not mean that a regulatory approach cannot be part of the solution. Underinsurance is a complex problem that calls out for creative, multifaceted solutions that involve insureds, insurers, producers and regulators. In order to be successful, regulatory efforts should allow for a certain amount of flexibility in the process, while providing guidelines that will be effective in allowing insureds to obtain the most accurate and useful replacement cost estimates. In the meantime, however, policyholders should not just sit back and wait for a regulatory solution. They should be proactive in reviewing their coverage to make sure they have purchased an adequate amount of insurance in the event of a catastrophic property loss.

—By Kristin S. Heres, Zelle Hofmann Voelbel & Mason LLP

Kristin Heres is a senior associate in Zelle Hofmann Voelbel & Mason's Boston office, where she is a member of the firm's insurance and reinsurance practice groups.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Insurance Industry’s Property Undervaluation Issue Continues to Improve According to Marshall & Swift/Boeckh, PR NEWSWIRE, Aug. 7, 2013.

[2] Cal. Code Regs. tit. 10, § 2695.183 (2014).