When underwriting for commercial properties, insurers need to obtain accurate insurance-to-value (ITV) calculations so they can charge the right premiums for the risks assumed. Adequate ITV should not be taken lightly. If insurers do not receive accurate values for the properties they insure, technical pricing will be based on faulty data, and their long-term financial stability could be at risk.
However, there often are not many incentives for agents and brokers to calculate accurate property and business interruption (BI) values. Higher insurance values can mean higher premiums, and agents and brokers obviously look to keep premiums as low as possible for their clients, which can affect ITV assessment. Furthermore, few commercial insurance contracts contain penalties for reporting inadequate values.
A concern for buyers
Insurers also play a role in the problem when they renew a program at expiring values. Very often, underwriters will take values and rates from the previous year and roll them forward 12 months. By failing to reappraise property values every five to seven years, insurers may find they have not considered the rising costs of labor and construction materials in premium calculations.
Inadequate ITV is not just a problem for the insurance industry — it also can be detrimental to policyholders, particularly homeowners who are underinsured. Many insurers of homeowners offer “guaranteed replacement cost” coverage, but it generally is only provided in their “preferred” programs and is limited to a modest amount (usually 20 percent to 25 percent) above the actual amount of coverage purchased. Many homeowners may find that their policies will not cover the replacement of their homes, if they face a total loss.
Setting the stage
An insurer might find that many underwriting files do not contain physical damage (PD) and business interruption (BI) worksheets for key commercial locations. It is common to find that little is done to assess the accuracy of PD and BI values.
Those reviews have made it clear that inadequate ITV is common in both hard and soft markets. Property rates have hardened after the shock losses of Katrina, Rita and Wilma. However, as the 2005 hurricane season demonstrated, the exposures are enormous, and primary rates may begin to slip when the shock losses of 2005 have been absorbed by the industry. In both hard and soft markets, insurers would be wise to develop contract language that provides customers, agents and brokers with the incentive to report adequate values.
For example, insurers could use a coinsurance provision that limits the amount of loss paid if values are not reported as indicated by the insurance contract. Other options are the use of margin clauses, which limit payment to no more than 125 percent of reported values, and location-limits-of-liability, which cap the amount of recovery to the value reported in the policy. If those tools are not used, underwriters may find they have to pay 100 percent of all losses, no matter how much the account is undervalued.
No quick fix
There is no quick fix to inadequate ITV in the property insurance industry. Yet it can be addressed if an insurer makes it a corporate priority, starting at upper levels of management and driving the initiative throughout the organization. It takes an ongoing commitment to assure consistent underwriting behavior during both soft and hard markets.
Underwriters must be trained on ITV issues, and they must be given the resources necessary to assess ITV adequacy. Bonus incentives can keep underwriters focused on ITV throughout the year.
It is not enough to communicate ITV commitment internally; a similar message must be sent to agents and brokers, so that they also know how important proper ITV is to the organization.
Some physical-damage lessons learned
During its review of clients’ claims files, GE Insurance Solutions learned some invaluable lessons that can help agents, brokers and insurers calculate real property values in the area of physical damage:
For leased buildings, it is important to make sure that full replacement values are reported to the insurer, rather than the amount that the lessor requires to be insured, which can be significantly less than the property value.
Architect and engineering fees, as well as construction and administrative overhead, must be included in the building value because they represent part of the replacement costs of a building.
Geographic labor costs can fluctuate by as much $30 per hour from the national average. Therefore, they must be considered when valuing property.
Underwriters should reflect the decline in value due to depletion, wear and tear, or obsolescence, rather than the property’s “book value,” which should be used only for accounting purposes.
Local building codes, ordinances and laws that regulate the reconstruction of damaged buildings and structures can add significantly to building replacement cost.
Some BI lessons learned
BI is one of the least understood property coverages, so proper ITV can be elusive. Anyone who develops BI values should have an understanding of the accounting process.
BI covers “loss of net profit, which would have otherwise have been earned if no loss occurred,” “normal expenses that necessarily continue” and “additional expenses incurred to the extent they minimize the reduction in income.” When establishing proper BI values, the insured must project net sales and offset expenses for the upcoming year.
While the income statement is the most useful tool in preparing BI values, net income is not. An income statement takes net sales and subtracts “cost of goods sold” to obtain gross profit. It then subtracts selling and administrative expenses to get to net income. Net income figures should not be reported because many of the expenses in the cost-of-goods-sold category are not allowable deductions. Examples of expenses that cannot be deducted for BI purposes are utilities, accounting and legal fees, rental payments, repairs, maintenance, travel and entertainment.
An issue of importance
The problem of inadequate ITV should not be taken lightly. ITV affects the accuracy of risk evaluation and pricing — and an insurer’s bottom line and profits. ITV often is an oversight, but it needs to be addressed now that Hurricanes Katrina, Rita and Wilma have set a new benchmark for the losses that are possible with catastrophic exposures.
Tom Smith, is vice president, regional product leader, for GE Insurance Solutions.
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