When it comes to Property underwriting, one critical element that is often overlooked or misunderstood is Commercial Property Valuation. This post contains some key insights on the subject.
They say it takes a village to raise a child. Well, similarly, in the commercial insurance property arena, it takes a village to raise real property valuation.
When it comes to Property underwriting, the first thing that typically comes to mind is COPE - Construction, Occupancy, Protection, Exposure - followed by an evaluation of the perils that would most likely trigger a property loss. But one critical element that is often overlooked or misunderstood is Commercial Property Valuation.
While the goal of Property insurance is to restore the insured back to the same financial condition that existed prior to loss, determining what a particular property is worth in the event of a loss and how that amount will be determined is not a black and white issue. Commercial property valuation is a complex subject, filled with numerous valuation options, policy provisions, and underwriting and legal concepts.
If you add to that the sheer number of parties involved in the insurance transaction, you add yet another layer of complexity to an already complex issue. This includes insureds, agents and brokers, underwriters, banks, contractors, inspection companies, claim adjusters, all of whom have different levels of expertise, and at times, competing goals.
The Statistics Tell the Story
It is estimated that in the U.S., 75% of commercial businesses are underinsured by an average of 40% or more. - Marshall & Swift Boeckh research
Up to 40% of businesses fail after a disaster. - Insurance Information Institute
Now consider the consequences of inadequate limits:
- Insureds are left with unrepaired damages, forced to pay out of pocket expenses to rebuild property back to pre-loss levels or, in the worst case scenario, forced to go out of business.
- Insurance companies, agents and brokers face unsatisfied claimants, leading to disputed claims, lawsuits, bad faith claims and E&O claims.
- Insurance companies are left with a book of business beset with depressed insurance premiums since property rates are applied to inadequate property limits, further compounding the effect of an already soft property market.
Let’s look at what can be done on the front end to eliminate such negative outcomes.
The Upfront Underwriting Process
1. The question that agents and brokers should be asking on every Property insurance account is, “What does the insured expect to recover in the event of a loss?” All parties then need to understand the coinsurance provision and the various valuation options (Replacement Cost, Actual Cash Value, Functional Replacement Cost, Agreed Value, and Flat /No Coinsurance) available to meet a particular insured’s needs.
2. Underwriters then need to determine if the Property insurance limit makes sense, given the building's characteristics and valuation option requested. To compute Insurance to Value, use the following formula:
Building limit / Coinsurance % / Square Footage= Cost per Sq. Ft
Numerous resources are available to help establish and confirm property valuation - cost estimating software, inspection and appraisal companies, real estate websites, etc. - but since property valuation is not an exact science, the goal is to assess whether the limit requested is at least in the ballpark.
Quick tips on property valuation to help get it right:
- Question the limits stated on the application. $80/sq. ft. for a frame apartment building may make sense in Texas for replacement cost (RC), but put that same apartment building in California or New York and a red flag should be immediately raised, as RC values would be well in excess of $175/sq. ft.
- Use the inspection report for checks and balances. Determine if policy limits are in line with the inspection report (within some ballpark percentage) and if they aren't, address and document any discrepancies with the agent. Consider increasing values appropriately or changing the terms; reduce from Replacement Cost (RC) to Actual Cash Value (ACV), for instance. While we can’t dictate the values the insured must use, we can at least provide guidance and education.
- Don’t rely on a coinsurance penalty for underinsurance. While the coinsurance provision certainly serves as protection for underinsurance, if no losses ever occur to the property, there would never be a penalty imposed on the insured. The insurance carrier, however, is penalized since the rate charged is applied against a low limit, leading to inadequate premium for the risk. Further, since determining the correct limit is not always clear cut, it typically is only practical to apply a coinsurance penalty when underinsurance is blatant. Finally, no insured wants to incur a coinsurance penalty at the time of the loss, so it is best to ensure that limits are adequate upfront.
- Recognize when you see Market Value. It’s common for insureds to mistakenly equate the purchase price of a building with the desired Property insurance limit, but typically one has nothing to do with the other. Market value refers to what a willing buyer would pay a willing seller, and has nothing to do with the actual “sticks and bricks” construction costs. Market Value also includes the value of the land, which is uninsurable and not part of the cost to rebuild; this is a concern when mortgagees require insurance equal to the loan value.
- Understand the difference between Agreed Value and Flat/No Co requests. Both options suspend the coinsurance condition but are the exact opposite in their intent. Agreed Value, often requested by banks, is appropriate for well-maintained buildings that are insured in line with replacement cost. In this case, carriers in essence are “agreeing” that the limit makes sense for RC and are thus willing to suspend the coinsurance provision for a small surcharge in rate. Conversely, when a Flat/No Coinsurance option is requested, the carrier is knowingly underinsuring the property, in exchange for a significant surcharge in pricing. In a common example for this request, an insured purchases a building for a bargain and only wants to cover the purchase price. This option also negates the moral hazard that could exist with insuring a building for considerably more than the fair market value.
- Challenge market pressure and complacency. All too often we see a general acceptance among markets to accept lower cost per square foot values as the norm. It’s the old, “But so and so is doing it” mentality. If one carrier agrees that $75/sq. ft. makes sense for a joisted masonry mercantile risk at RC, but another carrier thinks $125/sq. ft. is more in line with the value, which carrier is more likely to get the deal? Sure, the insured will be paying lower premium on a lower limit, but when a loss does occur, does an agent want to face an unhappy insured who has incurred a coinsurance penalty? And what about those accounts that renew year after year with the same Property insurance limits? Yesterday’s building limit may not reflect today’s rising cost of building materials. Be a resource to your agents and reevaluate Property limits for accuracy at the time of the renewal.
While there is no single underwriting rule that applies to every account, it is imperative that good judgment be used when determining property values. It is critical to understand the impact that proper valuation has on both the upfront underwriting process and the back end claims adjustment process, as they go hand in hand. Finally, communication among all parties - agents, brokers, underwriters and claim examiners/adjusters - is critical to successfully raise property valuation.
For more information on the various valuation options, contact your General Star Underwriter. We are here to help our clients think through their accounts.