On Target

In my past life as an insurance broker, I learned early on that property should be “insured to value.”

Insurers gave “discounts” and offered better coverage (all risk vs. named perils) if you were so protected. Back then, stated amount co-insurance either hadn’t been invented or was not in common use. Coinsurance policies require the owner of a damaged property to have another policy covering a vast majority (usually at least 80%) of the cash value of the property at the time of damage in order to collect the full amount insured. “No-co” policies were available, but with a much higher rate per unit of insured value.

And so, in my consulting practice, when I am in the identification phase of the risk management process, I feel that reviewing replacement costs of real and personal property is essential.

So, what is “replacement cost?”

REPLACEMENT COST

Referring to the FM Pro Vision form we see the following definition: “Basis of Valuation: Adjustment of loss amount(s) under this policy will be determined based on the cost of repairing or replacing (whichever is the lesser), at the time of loss, with materials or equipment of like kind and quality without deduction for depreciation, except as provided in this valuation section.”

I feel this policy definition provides little direction. (I will limit this discussion to buildings.) In practice, it should include allowance for demolition of damaged and undamaged portions of the building, increased costs of bylaw compliance, debris removal, site preparation, soft costs and finally the actual cost of rebuilding.

In a recent project involving a large hospitality operation, I asked the owner what he thought it might cost per square foot to rebuild his 20-year-old hotel. He estimated $175 per square foot. But his insurance policy’s declared value, unbeknownst to him, was $145 per square foot. In discussion with a quantity surveyor familiar with the property, the cost to rebuild was estimated to be about $250 per square foot. With allowance for the costs outlined above — i. e. those not contained within the definition of “valuation” — the number increases to almost $300 per square foot. In other words, the hotel was insured half to value. The building portion of the blanket property limit was promptly increased to $90 million.

During the insurance review of a large resort in an unprotected area, I determined the property insurance limit was based on a rebuilding cost of $135 per square foot. I encouraged the owner to hire a quantity surveyor to determine the current cost of replacement and take into account factors referenced above. At a cost of $10,000 for the project, the quantity surveyor reported a replacement cost of $342 per square foot. We promptly more than doubled the policy limit to $30 million. The additional premium was significant.

You might suspect these examples are the exception. From my experience, they are not.

CO-INSURANCE

Upon questioning brokers, I am often told that since the values are blanketed under the “property of every description” (POED) policy terms, and the co-insurance clause is “stated”or “agreed” amount, there is no real concern about any element of underinsurance. In the early stages of any review engagement, I request the broker to provide a copy of the signed statement of values provided the underwriter at the last renewal. It is very common to learn that one was not submitted. For example, the broker of an educational institution for which I was consulting recently advised me that since the insurer hadn’t asked for the signed statement of values at the last renewal, it wasn’t provided.

When I looked at the stated amount co-insurance clause in the educational institution’s policy, it said: “The terms and conditions of this clause shall cease to be in effect and the terms of the substituted coinsurance clause shall be reinstated 60 days after the effective date of the policy if the insured fails to file a new statement of values within the time required by this clause.”

So the institution was in fact not protected by a stated amount co-insurance clause; rather, it was covered by a 90% coinsurance clause. A review of values determined that some buildings were insured for less than half the cost of replacement; the policy had been renewed “as is” the last few years.

Upon further inspection, the educational institution’s policy contained a margin clause. This kind of clause can limit payment for a loss at any location in several ways. One way is to limit the loss payable to a percentage — i. e. 115% — of the value reported on any location or structure, even though the values were blanketed. So much for POED.

So, not only was this institution a coinsurer

of at least 50%, according to their policy, they were limited to 115% of the value declared to the insurer on each building — except that the insured had not filed a statement of values. Now what?

The broker had relied on something that didn’t exist. Fortunately, there was no loss. Had there been one, litigation would have been inevitable.

The annual filing of a statement of values is essential and must be done in a timely fashion. Most insurers use a similar version of this form. Some brokers use a simplified version; to my amazement, insurers accept them.

A standard version of a statement of values includes the following: “I/We hereby certify that the values given herein represent to the best of my/our knowledge and belief, the actual values of the property described, if to be insured on ACTUAL CASH VALUE BASIS; or cost of replacement of the property described, if to be insured on a REPLACEMENT COST basis, and…

“The attention of the signatory is drawn to Statutory Condition #1 of the Fire Policy, which reads as follows:

“Misrepresentation -1. If any person applying for insurance falsely describes the property to the prejudice of the insurer, or misrepresents or fraudulently omits to communicate any circumstance which is material to be made known to the insurer in order to enable it to judge of the risk to be undertaken, the contract shall be void as to any property in relation to which the misrepresentation or omission is material.”

Here we have a statement that suggests the insurer will accept the applicant’s best estimate. In fact, some brokers actually insert the phrase “insured’s best estimate” in the phrase in Item (d) of the form, which states: “The values appraisal for property mentioned in Columns 2 and 3 (Buildings, Machinery, etc.) was made: (date) ____by: ______.” The problem with estimating in this fashion is that if you are guilty of a “material misrepresentation,” you have no insurance. Oops.

What does a “material misrepresentation” mean in this context? Could this mean that your “appraisal” is grossly understated, even though it is based on your best knowledge and belief? To what degree does your estimate have to be off base in order to void your policy?

COMPLETING FORMS

Clients often advise me that their broker completed the form for them and simply requested signature because that is what the insurer requires. In a current project, the broker’s enclosure letter with the statement of values advised: “This is for the property values. Please review, sign and return to our office for head office records.” There was no explanation, only a request to review, sign and return. The client has no idea why a signature is required or the consequences of a misstatement. It is likely that if this client really understood what he was signing, and why, he may have asked a question or two.

By any stretch of the imagination, this whole process is not taken seriously enough. And yet, the downside consequences are very onerous. In a hard market, insurers are more diligent in ensuring that properties are reasonably “insured to value.” In the current soft market, this whole process isn’t receiving nearly as much scrutiny.

Last year, I was involved w ith a company that sustained a major fire loss of just under $10 million. The stated amount clause, which the mortgagee required to be part of the policy, was missing. The policy was written on a blanket POED basis and subject to a 90% co-insurance clause. Two of 20-plus buildings on site were destroyed by fire.

The insurer’s adjuster attended the site and noted there were footings and foundations on the property in preparation for future expansion; these were not included in the statement of values. The cost of their replacement was well over $1 million. The adjuster included this amount in his coinsurance calculation. The broker was aware that these footings and foundations were on the property. After the fire, the broker advised there was no intent to insure the footings and foundations until they were to be used in the further construction of additional buildings.

It is usually desirable to have blanket limits. However, beware when completing statements of value: if you don’t intend to insure certain buildings or include specific fixed assets, it is recommended they be specifically excluded by endorsement, so as not to be included in the determination of blanket limits post loss.

After many years of dealing with the concept of “insurance to value,” I am still amazed how rarely it happens in practice and how often the concept really is misunderstood. In the competitive world of insurance, “insurance to value” is often overlooked, placing the insured property owner in great jeopardy.