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 they assume.
Adequate ITV is not an issue to be taken lightly. If insurers do not receive accurate values for the properties they insure, their technical pricing is 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. As higher insurance values can mean higher premiums, agents and brokers are obviously looking to keep premiums as low as possible for their clients, which can affect their assessment of ITV. Further, few commercial insurance contracts contain penalties for the reporting of inadequate values.
Insurers also play a role in the problem when they renew a program at expiring values. Very often underwriters will take the values and rates from the previous year and roll them forward for the next 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 their premium calculations.
Also a concern for insurance buyers
But inadequate ITV is not just a problem for the insurance industry itself; it also can be detrimental to policyholders, particularly homeowners who are underinsured.
Many insurers of homeowners offer “Guaranteed Replacement Cost” coverage–but generally it is only provided in their “preferred” programs and it is limited to a modest amount (usually 20 percent to 25 percent) above the actual amount of coverage purchased. Therefore, many homeowners may find that their policies will not cover the replacement of their homes, if they face a total loss.
Setting the stage
In a review of underwriting files, an insurer might find that many files do not contain physical damage (PD) and business interruption (BI) worksheets for key commercial locations. In fact, it is common to find that little is being done to assess the accuracy of PD and BI values.
These reviews have also made it clear that inadequate ITV is a common problem in both hard and soft markets. Property rates have hardened after the shock losses of Katrina, Rita and Wilma, and one could argue that rates are high enough to compensate for any deficiency in values. However, as the 2005 hurricane season demonstrated, the exposures are enormous and primary rates once again 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 these 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 the problem of inadequate ITV in the property insurance industry. But it can be addressed if an insurer makes ITV a corporate priority, starting at upper levels of management and driving the initiative throughout an 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 tools and resources necessary to assess ITV adequacy. Bonus incentives can be used to keep underwriters focused on ITV throughout the year.
But it is not enough simply to communicate the ITV commitment internally; a similar message must be sent externally to agents and brokers so 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 has 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 overheads must be included in the value of the building because they represent part of the replacement costs. (On average these fees represent 7 percent of the total building cost.)
Geographic labor costs can fluctuate up and down by as much $30 per hour from the national average and therefore must be considered.
Underwriters should reflect the decline in value due to depletion, wear and tear or obsolescence, rather than considering 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 the replacement cost of a building. A good example of this was the experience of insurers after the Northridge earthquake when replacement costs of some buildings were increased significantly due to legal and regulatory building requirements.
Some BI lessons learned
Since BI is one of the least understood property coverages, it is the area where proper ITV is the most elusive. As a result, anyone who develops BI values should have a basic 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.” In establishing proper BI values, the insured must project its net sales and offsetting expenses for the upcoming year.
While the income statement is the most useful tool in preparing an insured’s business interruption values, net income should not be used in BI calculations. 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 for BI purposes because many of the expenses that are included in the cost-of-goods-sold category are not allowable deductions in the determination of BI values.
Examples of such expenses that cannot be deducted for BI purposes are utilities, accounting and legal fees, rental payments, repairs and maintenance, and travel and entertainment. Therefore, it is important to make sure insureds are not simply taking net sales and deducting cost of goods sold to reach BI values. Doing so would understate BI values considerably.
Issue of importance
The problem of inadequate ITV should not be taken lightly because ITV affects the accuracy of risk evaluation and pricing–and ultimately an insurer’s bottom line. Unfortunately, however, adequate ITV is often not a priority, despite the fact that it has a significant influence on a company’s profits. This is an oversight that needs addressing now that Hurricanes Katrina, Rita and Wilma have set a new benchmark for the losses possible with catastrophic exposures.
Tom Smith is vice president, regional product leader, for GE Insurance Solutions.
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