Catching Smoke

Claims adjusters are not typically involved in insurance- to-value (ITV) calculations, but they enter the picture when an estimate is out of whack with the actual replacement costs in a partial or total loss claim. This tends to happen more often with certain kinds of properties such as higher-end homes, recreational properties and some commercial buildings. As many insurers and brokers struggle to bring property valuations in line through various ITV software tools, the question is: Do valuations pass the claims test for accuracy?

Valuation estimates upon which insurance companies rate their property policies are just that — estimates. The cold, hard reality of a valuation’s accuracy is determined in the event of a partial or total loss claim. Acknowledged gaps between the reconstruction costs for personal or commercial properties and their initial valuations have preoccupied the minds of insurers, valuation vendors and brokers in recent months. But the exact size of these gaps becomes clear when a claim is filed and reconstruction costs make the transition from projected to actual costs. Enter the connection between ITV and the claims community.

Several insurance adjusters say they see discrepancies between initial valuations, which are often done by brokers on behalf of insurers, and reconstruction costs. “In my experience, the issue of underinsured or undervalued properties is a widespread one, given the actual costs for repair and replacement,” says Stephen Agnew, an adjuster with Crawford & Company (Canada) Inc.

Several different factors affect how well valuations stand up to real-life claims, according to adjusters. Some of these involve the type of property (including commercial), the size of the loss event, availability of qualified contractors, the geographic region, building codes and the terms and conditions of the actual insurance policy.

“Value is such a subjective term, it is like trying to catch smoke,” notes Fred Plant, president of Plant Hope Adjusters Ltd. “You can put everything into a computer program and try to determine the replacement cost, but you have no clue what the real replacement cost of that home is going to be until you rebuild it. And you can’t underwrite after the loss.”

The ITV issue is somewhat akin to a ticking time bomb. For example, it’s just a matter of time before a major or even minor catastrophe happens, be it a wildfire, windstorm, flood or earthquake event, observes Greg McCutcheon, president of SCM Risk Management Services, which recently acquired CGI’s risk management services. “It is not until these events occur that the industry realizes how far out they are [with their valuations],” McCutcheon said. “Even with guaranteed replacement costs (GRC), the problem is this: If the client is underinsured through no fault of his or her own, any claim is going to be delayed and problematic for the customer. That is not good for anybody.”

So then, how do valuation software estimates compare to the actual claims experience of insurance companies? “That is a question we get a lot from insurance companies,” says Todd Rissel, CEO and chairman of e2Value Inc., which has been promoting its valuation software on a free trial basis to brokers through Compu-Quote (up to January 2009). “If a company gives us their claims data and then asks us to compare, our answer is that it compares very favourably,” he says. “I don’t doubt that our estimator will match — if not right on, then closely — the claim value at the time of the incident on a total loss process.”

Still, he adds, the main sticking point for insurance companies on property valuations is whether or not previous estimates on their book of business are outdated (and if so, by how much). “Many of the properties might have been valued four years ago, and the company has been applying an inflationary number to it over that time,” Rissel says. “That company is betting that the initial valuation was done correctly and there will be some semblance of connection at the time of loss several years later. I think that is where the biggest disconnect is.”

Other valuation software vendors, such as Marshall Swift/Boeckh (MSB) and Powersoft, also maintain that their estimating tools, if used properly, closely match the claims experience of insurance companies. Yet claims representatives say the front-line level of adjusting can yield some surprises and delays not anticipated at the time of the initial ITV estimate.

VALUATION VARIABLES

Demand spike

Although several adjusters say standard residential properties are fairly straightforward to value, variables still apply in an actual claim situation. One is a demand spike for building contractors typically accompanying a large loss event or even a significant individual total loss.

“It is fine to have books, valuation and square footage, but there is a market component that kicks in,” notes Nick McDonald, senior vice president of quality and education for Cunningham Lindsey Canada. “In Western Canada, we have found situations in which it is difficult to get a qualified contractor, period — even before we get to the pricing. If there is a large-scale event, such as the Kelowna wildfires, you really are at the mercy of the market.”

“The demand bump happens all the time,” says Plant. “It could be a windstorm or a relatively small event that causes a bump. The insurance company might say: ‘Well our policy is that we only pay $193 per square foot.’To which the contractor responds:’Okay, forget it.’ So the company ends up paying $240 per square foot or more. The laws of supply and demand don’t simply go away.”

The laws of supply and demand are particularly relevant when it comes to certain geographic regions in Canada — especially in remote, “recreational” locations like Muskoka in Ontario or Whistler in British Columbia. “There are instances in which the replacement value of a structure is higher than the insured-to-value calculation in remote recreational areas, where the rebuilding price becomes somewhat inflated due to lack of true competitiveness within the marketplace,” says Agnew.

Property type

Another variable is the type of property involved in a claim. “You can see rows and rows of homes in subdivisions across the country that are almost exactly identical, but there is a large proportion of homes that are not built that way,” notes Plant. “It is very difficult to come up with something that will take into consideration all the facets of a unique home. The valuation program vendors will say:’Well, we have built that in, we do this and that,’ but it is all based on averages. It is not an exact science.”

There have been some instances over past few years in which the reconstruction cost of a total loss exceeded the insurance-to-value calculation, Agnew says. “These are more prevalent in older, higher-end homes in which there have been significant upgrades of the interior finishes.”

Building codes also affect ITV estimates because there can be confusion about which code — i. e. municipal, provincial or federal — applies. If a policyholder files a partial or total loss claim and has code or bylaw coverage, the reconstruction will reflect the higher costs associated with the upgrade.

“One of the items that can really drive a policy sideways, especially on an older building, is code upgrades that are in fact covered by the contract,” says Mc- Donald. “That would be true in both personal and commercial lines. If the policy covers code changes, you can be looking at differences under the various municipal or provincial or even national codes.”

ITV AND COMMERCIAL LINES

ITV miscalculations are more likely to appear in some kinds of commercial properties, claims representatives observe. This is becoming a higher-profile issue, since several insurance companies are experimenting with offering GRC on commercial buildings. McDonald notes that he has seen more commercial policies featuring GRC, which, put basically, offers to rebuild the building at full replacement cost, even if that cost rises above the limits set forth in the policy.

ING Canada has recently started a pilot of GRC commercial coverage (buildings only) in a number of provinces. ING spokesperson Gilles Gratton says the company is trying to learn if GRC is more effective in reducing the under-insurance gap and establishing correct insurance limits. The program is available to clients that participate in the company’s on-site valuation program and agree to insure to 100% of estimated replacement value.

However, there may be a higher margin of error in estimates for business buildings, some contend. “With respect to industrial/ commercial properties, accurate estimation of the replacement values becomes a complex engineering exercise,” says Ray Ballantine, senior general adjuster for Crawford & Company (Canada) Inc. “One has to ensure that all components and aspects of the building are in compliance with the present building code, as well as all health and safety and environmental regulations.”

Ballantine notes insurers may sometimes overlook key factors in establishing ITV amounts for commercial properties; such oversights could “dramatically increase underwriters’ ultimate exposures.” He groups these factors into three areas: foreseeable, non-foreseeable and assumed.

An example of a foreseeable issue could relate to problems with the application of computer valuation technology and real estate appraisals when applied to loss adjustments. Ballantine cites a recent case involving a hotel restaurant and a computer- generated estimate that determined a lump sum value for commercial kitchen equipment. The lump-sum value was calculated on a basic, per-square-foot allowance. A review of the computer program showed the estimate accounted for the cost of items based on what the programmers “felt” would normally be found in a hotel restaurant. It did not, however, include normal acthe cessories, delivery to a remote site and set-up or connections. The actual costs were therefore four times higher than the computer-generated values.

A non-foreseeable issue could extend to differences between provincial and national building codes. In one example, permits were issued for a warehouse to be constructed outside Montreal in 1996.The warehouse was legally designed to the building code at the time the permits were issued. (Quebec had not accepted the 1995 National Building Code, so the code in existence was 1990.) Construction on the warehouse was completed in 2000 and a loss occurred in 2001. At the time of the loss, authorities demanded that repairs be compliant to the 2000 National Building Code, which the province had accepted subsequent to the issue of the permits. This drastically increased the underwriter’s exposure: it required the insurer to satisfy the costs for all bylaw upgrades instituted during the previous 10 years — for a building that was only eight months old at the time of loss.

An assumed risk in a commercial ITV estimate typically involves packaging a number of coverages into one policy, according to Ballantine. “Regardless of any ITV based on a reported statement of values for the building(s), underwriters agree to include within a single maximum limit such items as business interruption, extra expense and bylaw coverage at no additional cost, thus increasing their ultimate exposure,” he states.

ITV CLAIMS SOLUTIONS

Solutions to finding the closest match between ITV estimates and actual reconstruction costs in a claim vary depending upon the source. Some say there is a need for more professional appraisals, particularly for certain kind of properties.

“A professional appraisal firm should be used when valuing higher-end custom homes, older homes with plaster finishes, upgraded mill work, as well as areas involving higher-end recreational properties, where there may not be enough contractors in the area to create a true competitive bid situation,” notes Agnew.

McCutcheon, whose firm offers these kinds of loss inspection services, argues that nothing can replace an accurate, personally inspected property appraisal. “But realistically the industry cannot afford to inspect every single property,” he says. He contends the primary issue is one of data quality at the start of the ITV process. He notes that he and a broker once undertook a study of 6,800 policies; they found more than 50% of the valuation information was inaccurate. “This is a data accuracy issue,” McCutcheon says.

On the topic of data accuracy, Rissel says:”We dedicate a lot of time to making sure that we reduce as many errors as we can up-front. The notion of ‘garbage in, garbage out’ will always apply, but we want to limit errors in any input and take advantage of technologies available today to help people answer questions. We want to make sure that piece has a better correlation with total loss values.”

The key is that this is not a software calculator matter, Mc- Cutcheon says. “All of the models are used and accepted by our industry. Instead, there are two issues: the accuracy of the information and the technical expertise to assess the data. There is a huge training and education process that has to occur in this industry.”

Claims adjusters say they would welcome such an education and training process. “If insurers go with ITV, they have to make sure that people all the way through the equation — from client, to broker, to underwriter, to claims adjuster — understand the ramifications of ITV, what it means and how it works,” notes Plant. “It is important to ensure that information is disseminated along the line in advance, before the claim hits.”

Agnew says it might also be advantageous for adjusters to “meet with groups of brokers to review and compare how insurance to value is established on a pre-loss to a post-loss estimate. In doing so, on a component by component basis, one could establish if there any specific items or areas that are either missed or being undervalued.”

If, as Plant says, establishing accurate property values is like “catching smoke,” the industry needs to do more to clarify the valuation process for brokers, insurers and claims adjusters. After all, if the industry finds it hard to agree on the “right” number, how could it expect consumers to understand what their property is worth before and after a loss?