Construction Cost IncreasesCreate Underinsurance Hazardfor Commercial PropertyInsurance Buyers
Remember inflation? It’s back and it does somuch more than just raise prices. Big increasesin the cost of construction and property repairover the past year are making underinsurance agrowing problem for businesses.
A company is underinsured when its insurancecoverage does not adequately cover the cost ofa loss. It becomes more of a problem duringtimes of inflation because the value of the itemsinsured rises over the course of the policy term.Insurance buyers give their insurers a list ofinsured values, and generally that’s what theinsurers will pay, even if the value has gone upand the insurance payment does not in the endcover the loss.
How steep is the increase? The cost of buildingcommercial and industrial buildings in the US hasincreased 11 percent in the past 12 months,according to industry sources. The leading causeis unprecedented increases in the prices of steel,cement, petroleum products and shipping.Adding more pressure to the cost of constructionmaterials is the construction boom occurring inChina, allowing increased demand to work itsmarketplace magic.
To sum it up, property insurance buyers who useda year-old statement of values for their July 1renewals could be underinsured by something onthe order of 11 percent.
Inflation may raise the level of theunderinsurance problem, but is not the solecause. In the hard market of the past severalyears, property insurance underwriters havebeen strict about penalizing insurance buyers
whose insurable values are understated. Themost common penalty is to restrict payment onany claim to the amount reported on thestatement of values. Sometimes, underwritersoffer wiggle room – often around 10 percent –in cases where the amount of the claim exceedsthe values reported.
Another way underwriters penalize insurancebuyers is by invoking a coinsurance clause that isincluded in some policies. In the event a claimexceeds the insurable values, loss payments arecalculated according to the following formula:the amount declared on the company’sstatement of values is divided by the actual valueat the time of the loss. This ratio is applied to theloss amount, and the insurer pays the resultingamount. The remainder is the responsibility ofthe coinsurer, i.e., the insurance buyer.
In either penalty scenario, the underreportingof insurable values hurts.
What can be done about it? We recommendseveral strategies.
• First, and most obviously, exercise extracaution in the preparation of your statement of values. If you have several buildings ofdifferent ages but with similar occupanciescalculate the cost per square foot of thenewest. Then apply a recognized cost ofconstruction index multiplier to the cost persquare foot.
Finally, apply the inflation adjusted cost persquare foot to all of your similar buildings.
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Property Insurance BulletinJuly 2004
Cost of ConstructionIndex Multiplier
Date of Construction
July 2004 1.00July 2003 1.11July 2002 1.13July 2000 1.20July 1996 1.30
To sum it up, propertyinsurance buyers whoused a year-oldstatement of values fortheir July 1 renewalscould be underinsuredby something on theorder of 11 percent.
• Consider getting updated appraisals, starting with yourlargest facility and then working your way down the list.
• Consider getting business interruption values prepared andcertified by a CPA who specializes in preparing accountingrecords for business interruption claims for insurance buyers.(Business interruption values are one of the two maincomponents of a list of insured values; the other is physicalproperty values.) If your business has interdependencies,prepare flow charts for the underwriters.
• Make sure your loss prevention surveys are accurate and upto date.
• Remember the first rule of underwriting: if there is a gapbetween the information your underwriter needs and whatyou provide, the underwriter will fill the gap – at your expense. On the brighter side, underwriters give their bestprices and conditions to insurance buyers who have a goodstory and tell it well. With construction costs rising, it is morecrucial than ever to tell a convincing – and accurate – storyon property insurance values.
Coinsurance Formula: When Claims Exceed Insurable Values
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Amount InsuredActual Value
X Loss =Claim
Payment
$800,000(the declared value of Property A)
$1,000,000(the actual value of Property A)
X$50,000(Fire Loss)
=$40,000
(Paid to owner)
The owner of Property A must cover the remaining $10,000
Property Practice Contacts
Practice Leader:
Suzanne DouglassManaging Director, North America Property Practice New York, NY Tel: 212 804 0516Fax: 212 344 2780 [email protected]
North American Resource Group:
James H. CostnerSenior Vice PresidentWillis Risk SolutionsNashville, TN Tel: 615 872 3421Fax: 615 872 [email protected]
Martin Grafton-GrattanSenior Vice President, Property Resource GroupWillis Risk SolutionsNashville, TN Tel: 615 872 4417Fax: 615 872 [email protected]
Earl OwenSenior Vice President & Senior Resource ConsultantWillis North AmericaBoston, MA Tel: 617 351 7532Fax: 617 351 [email protected]
William S. RodgersSenior Vice President and ConsultantWillis Risk SolutionsNashville, TN Tel: 615 872 3425Fax: 615 872 [email protected]
Gary E. SchmalenbergerSenior Vice President & DirectorWillis Risk SolutionsBaltimore, MDTel: 410 527 7234Fax: 410 527 [email protected]
Willis North America, 07/04
