What the form is
The HO 05 31, Modified Functional Replacement Cost Loss Settlement endorsement, alters the standard loss settlement provisions in a homeowners policy for the dwelling (Coverage A) and other structures (Coverage B). Instead of settling losses based on full replacement cost with identical materials, this endorsement provides for settlement based on "functional replacement cost". This means the insurer will pay the amount it would cost to repair or replace the damaged building using less costly, common construction materials and methods that are functionally equivalent to the original, often more expensive or obsolete, materials and methods (e.g., replacing plaster walls with drywall).
The "modified" aspect of this endorsement is crucial: if the necessary amount actually spent to repair or replace the damaged part of the building is less than its actual cash value (ACV) at the time of loss, then the loss will be settled on an actual cash value basis.
Classes of business it applies to
This endorsement is designed for use with specific homeowners insurance forms, typically HO 00 02 (Broad Form), HO 00 03 (Special Form), and HO 00 05 (Comprehensive Form). It is most commonly considered for older homes where the architectural style may be obsolete, or the cost to replace unique, antique, or custom features with identical materials would be disproportionately high compared to the home's market value or the insured's needs.
Real-world example: An insured owns a 100-year-old home with ornate plaster crown molding that is damaged in a covered loss. Under the HO 05 31 endorsement, the insurance company might pay to replace the damaged molding with a standard, functionally similar (but less expensive) modern molding. If the cost of this functional replacement is, for instance, $1,000, but the actual cash value of the original damaged plaster molding was $1,200, the settlement would be $1,000. However, if the functional replacement cost was $1,500 and the ACV of the original molding was $1,200, the settlement would be $1,200 because the ACV is less than the repair cost in this scenario, triggering the "modified" provision if the repair cost is less than ACV (this part of the example illustrates the general principle, the trigger is if repair cost is *less* than ACV, then ACV is paid).
Special considerations
- This endorsement allows homeowners to insure their property for a limit that reflects the cost of functional replacement, which might be lower than full replacement cost, potentially making the insurance more affordable.
- It is critical that the insured understands that in the event of a loss, repairs will be made with modern, functionally equivalent materials, not necessarily like-kind materials, which might alter the aesthetic or historical character of the home.
- The provision that settlement will revert to ACV if the repair/replacement cost is less than the ACV of the damaged part is a key differentiator from the standard Functional Replacement Cost Loss Settlement endorsement (HO 05 30).
- For the functional replacement cost settlement to apply (up to the policy limit), the amount of insurance carried on the damaged building must typically be 80% or more of the building's functional replacement cost immediately before the loss, and the insured must contract for repair or replacement for the same use within a specified timeframe (e.g., 180 days), unless otherwise agreed. If these conditions aren't met, settlement might be on an ACV basis or the functional replacement cost, whichever is less.
Key information for agents and underwriters
- Pricing: This endorsement can lead to a lower premium for the insured because it generally reduces the potential payout from the insurer compared to a full replacement cost valuation.
- Risk Assessment: Underwriters should consider this endorsement for older homes with unique or obsolete features where the cost of exact replication is excessive. It helps manage exposure on such properties. The difference between market value, actual cash value, functional replacement cost, and full replacement cost should be understood.
- Coverage Explanation: Agents must clearly explain to clients how this endorsement works, particularly the concept of "functional equivalence" and the circumstances under which ACV would apply due to the "modified" provision. Misunderstanding can lead to dissatisfaction at the time of a claim.
- Underwriting Guidelines: Insurers will often require a careful valuation to determine the appropriate functional replacement cost. A Home Cost Estimator (HCE) worksheet that applies a Functional Replacement Cost Factor may be part of the underwriting process. This ensures the Coverage A limit is adequate for a functional repair but not inflated by the cost of replicating non-essential or obsolete features.