Dear {Person},
I am so sorry to have lost the {item} that you entrusted me with. It was perfect for {occasion}. Unfortunately, {describe loss of item}.
Of course, my immediate reaction to this loss was to replace your {item} with one of equal value and quality. However, my research indicates that it is {no longer sold/very expensive}. You sure have good taste!
Would it be possible for me to offer up {similar item}? I know it's not exactly what you had, but it's what I can afford. Or, perhaps you'd like to replace it yourself? I could send you {amount} per month.
I feel just awful about this. I've never before lost a borrowed item and still can hardly believe what happened.
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