Evaluating Commercial Replacement Cost Estimates: Beyond the Numbers Part 2

This is the second in our series of guest posts from Michael Gay. Check out his bio at the end.

The Estimator Is a Tool, Not an Appraiser

Commercial replacement cost estimating systems are sophisticated tools. They can consider occupancy, construction class, square footage, number of stories, building height, exterior walls, heating and cooling systems, interior finishes, and numerous other characteristics.

But the software does not inspect the building. Someone must provide the information.

That distinction is critical. A sophisticated estimating system can produce a materially inaccurate result when inaccurate or incomplete information is entered.

Suppose an agent enters a 25,000 square foot building as a one-story masonry warehouse. In reality, portions contain finished offices, specialized electrical systems, extensive HVAC equipment, fire sprinklers, and better interior finishes than a typical warehouse.

The software may calculate precisely what it was instructed to calculate. The problem is that the building described to the software is not the building actually insured.

Precision Is Not Accuracy

The resulting report may look impressive. It may contain dozens of pages, detailed calculations, and a replacement cost figure down to the dollar. But apparent precision should never be confused with accuracy.

In litigation, that distinction can matter a great deal.

Defaults Deserve Scrutiny

Replacement cost estimating systems frequently contain default assumptions for building characteristics when more specific information is unavailable or not entered. Defaults can be useful, but they should not be mistaken for verified facts about the property. When an important characteristic has been assumed rather than confirmed, the user should understand whether that assumption could materially affect the resulting valuation.

Examine the Inputs Before Debating the Output

When I evaluate a disputed commercial replacement cost estimate, one of the first things I look for is the information entered into the estimator.

The final number tells only part of the story.

Among the questions that should be asked are:

1. Was the square footage correct? Compare the estimate with reliable building records, appraisals, architectural information, and, when appropriate, physical measurements.
2. Was the correct occupancy selected? A restaurant, supermarket, medical office, manufacturing facility and warehouse may have dramatically different construction characteristics even when their exterior dimensions are similar.
3. Was the construction class correct? Frame, joisted masonry, noncombustible, masonry noncombustible, and fire resistive construction are not interchangeable classifications.
4. Did you include all stories and building areas? Basements, mezzanines, additions, and attached structures are easy to overlook.
5. Were building systems properly described? HVAC, electrical, plumbing, elevators, refrigeration, and fire protection systems can materially affect reconstruction costs.
6. Was the quality of construction accurately characterized? Selecting an “average” assumption for a building with high-end finishes or specialized construction can significantly distort the result.
7. Were unusual features considered? Commercial kitchens, clean rooms, laboratories, specialized foundations, architectural features, and other nonstandard components may require additional attention.
8. Was the valuation current? Construction costs change, sometimes dramatically. An estimate prepared several years earlier may no longer support an adequate limit.

These questions are often more revealing than simply comparing two competing replacement cost figures.

The Site Inspection Matters

A recurring problem in underinsurance disputes is the adequacy of the information used to prepare the estimate.

Not every commercial account requires an independent professional appraisal, and an insurance producer should not be expected to function as a construction estimator. But the more complex the building, the more dangerous it becomes to rely on assumptions.

A physical inspection, carrier inspection report, photographs, building plans, prior appraisal, or detailed discussion with the insured can identify characteristics that may never appear on a basic application.

If the property is a supermarket, for example, does the valuation contemplate extensive refrigeration and electrical systems? If it is a restaurant, did the valuation consider commercial kitchen systems? If there is a basement, did you include it? Were additions made over the years? Has the occupancy changed?

These questions aren’t trivial when millions of dollars of property are at risk.

The Consequences of Getting It Wrong

This is where replacement cost estimating moves from underwriting procedure to serious financial exposure.

Assume a commercial building is insured for $3 million but costs $6 million to replace after a total loss. “Replacement cost coverage” does not magically produce the missing $3 million. Subject to the policy’s terms and conditions, the insured may have purchased an inadequate amount of insurance.

A partial loss can also create problems when the policy contains a coinsurance requirement, and the amount of insurance does not satisfy it.

The insured may then ask a predictable question: How did we end up with this limit? That question can lead directly to the agency file.

Who selected the limit? Was it requested by the insured? Recommended by the agent? Generated by an estimator? Required by the insurer? Carried forward from an earlier valuation? Did the insured provide the building information? Did the agent inspect the property? Were discrepancies identified? Did the agent recommend a higher limit that was rejected?

Those questions frequently become important in expert witness assignments involving allegations against insurance agents.

Don’t underestimate the potential consequences for the agent. A serious underinsurance allegation can produce an E&O claim involving hundreds of thousands or millions of dollars. It can also require reconstruction of conversations and decisions made years earlier, sometimes by employees who are no longer with the agency.

Replacement Cost and the Policy Limit Are Different Questions

Another important distinction is between estimating replacement cost and selecting an insurance limit. An estimate is evidence supporting a valuation decision. It is not the insurance contract itself.

Agents must consider how the valuation interacts with coinsurance provisions, agreed value provisions, blanket limits, valuation clauses, and applicable endorsements. Ordinance or law exposures, debris removal, and other reconstruction-related costs can also affect whether the overall insurance program is adequate.

An insured can therefore have a reasonably accurate replacement cost estimate and still have an inadequate insurance program.

Conversely, eliminating a coinsurance penalty does not eliminate underinsurance. A policy without coinsurance can still leave an insured millions of dollars short following a total loss if the building limit itself is inadequate.

About the Author

Michael Gay, CPCU, AAI, AAI-M, AINS, AIS, ARM, CRIS, RMPE, is an insurance consultant, educator, author, and expert witness with more than 40 years of experience in the property and casualty insurance industry. His career has included executive leadership at insurance carriers, managing general agencies and retail agencies, as well as agency ownership. He co-authored with Patrick Wraight Risk-Proof Your Business: The Complete Guide to Smart Insurance Choices—Expert Insights for Navigating and Mitigating Business Risks (Wells Media Group, 2024). He is the founder of Michael Gay Consulting, LLC.

Topics Commercial Lines