For most property insureds, the test of coverage may never occur. For
others, these words will be as important—if not more important—than all
other policy coverage terms and conditions:
- "We (Insurer) will pay for direct physical loss or damage … "
- "In the event of loss or damage covered by this Coverage Form, at
Our (Insurer) option we will …"
- "We (Insurer) will determine the value of Covered Property in the
event of loss or damage as follows …"
While a risk management professional should be concerned about what
may damage or destroy covered property,
an equal concern should be that the insured's settlement received post-loss
is appropriate to continue post-loss operations as if nothing had happened.
An insured's pre-loss expectations should be equal to the insurer's
post-loss policy (contractual) obligations.
A total fire loss occurs later in the coverage year at one location and
the insured learns that even a favorable renewal may result in an unexpected
coverage deficiency at time of loss settlement. How could this happen?
The policy excerpts listed above are taken from the Insurance Services
Office, Inc. (ISO), building and personal property coverage form, CP 00 10
04 02. These provisions are similar to that used in non-ISO property
insurance policies, so this loss scenario could happen to any risk
management professional. Exposure review for property insurance starts with
proper identification and determination of property and its
pre-loss value and how the insured
post-loss event may have it repaired,
replaced, demolished, or left as is.
Appropriate property risk management goes well beyond simply the
identification of perils that may cause damage, destruction or interruption
of operations; the pre-loss value, post-loss settlement options, and policy
coverage limit are also of key concern. Unless the insured uses an
appropriate "pre-loss" valuation process, coverage is flawed from policy
effective date. This flaw will impact the ability of the insured to obtain
at policy inception a coverage limit needed for total loss and the limit
will have a bearing on the insured's ability to cover debris removal, a
significant exposure resulting from direct physical damage.
All coverage discussion in this article is based on current ISO policy
forms. The reader is advised to review actual policy language, ISO and
non-ISO, to ascertain coverage impact for a real or hypothetical loss
situation. Understanding and addressing coverage issues pre-loss event may
limit post-loss event loss settlement issues including the need to litigate.
Values at Risk
Soft insurance markets may allow a risk management professional to obtain
coverage tools that can "overlook" possible deficiencies in property values
by providing blanket limits to make up for inadequate limits at any one
location, removal of a coinsurance requirement, and providing replacement
cost valuation. Hard markets and restrictive coverage renewal terms can
occur suddenly after catastrophic events, such as what happened to many U.S.
insureds after both September 11, 2001, and Hurricane Katrina.
Can an insured suddenly create appropriate building and contents values
when faced with stringent renewal terms such as limits specific per
location, coinsurance, and actual cash value loss settlement? For most
insureds, the answer is probably not. Establishing proper property insurance
values is an ongoing risk management activity that must be viewed
independently of current market conditions.
Risk management professionals should structure property insurance
programs whenever possible and, when cost effective, obtain blanket limits,
removal of coinsurance and proper loss settlement valuation—replacement cost
or actual cash value (replacement cost less physical depreciation). At the
same time, insureds need to construct the internal tools to ensure that
values for buildings and contents at any location are appropriate,
reasonable, and in synch with post-loss settlement expectations and the
insurer's policy mandated loss settlement obligations. Such tools will
become essential at time of loss to create timely proof of loss, serve as
means to document items lost or damaged, and to obtain timely and proper
loss settlement from the insurer.
Risk management professionals need to continually ask themselves if the
pre-loss values are appropriate to not only obtain broad coverage terms at
policy inception but also if the values and thereby limits post-loss will
provide the insured with timely and correct settlement from the insurer. Any
hesitation in answering this question will suggest that values may be flawed
and thus need to be reviewed more often than just during the renewal
process. Property risk management is an ongoing process, not one that needs
attention just 60 days prior to policy expiration.
The complexity of determining appropriate property values will increase
with each new location when viewed as a possible unique exposure unit
(building and/or contents), the geographic location of the unit (Southern
Florida—demand surge such as that following catastrophic windstorm),
occupancy functions within the building (many manufacturing processes under
"one roof"), and changing technology (buildings—increased functionality in
new/smaller physical plants in relation to old mill construction, and
contents—computers and computer-aided equipment—getting more productivity
for less cost). Simply applying a 2-3 percent inflation factor to an
existing statement of values may not be enough, especially for dynamic
organizations that frequently reinvent themselves through organic growth,
acquisition, and merger.
Consideration must be given to the possibility that total loss may
require permanent resumption of operations at a new site (building) and
permanent movement of critical machinery and equipment (contents) to new or
existing location(s), thus changing values at many locations, not just one.
Imagine a major loss occurrence will happen during the next year. Then ask
during the annual valuation process: Can we continue to operate at this
location? Will building ordinances require us to move? Should operations and
certain equipment be redeployed at other locations on a permanent basis? How
many of these "alternate" premises costs will be subject to coverage?
A decision to change the valuation of buildings or contents from
replacement cost to actual cash value must be reviewed carefully. The change
in value will obviously decrease the insurance limit for total loss and
reduce the potential for adequate loss settlement for other coverage
provisions. Debris removal coverage is predicated on 25 percent of the sum
of the deductible plus the amount paid by the insurer for the direct
physical loss or damage to covered property, not to exceed the limit of
insurance applicable to the covered property. A change from replacement cost
to actual cash value will cause a significant reduction in debris removal
coverage. While additional debris removal coverage may be provided by the
insurer upon specific request using "Debris Removal Additional Insurance,"
CP 04 15 10 00, the insured must consider the exposure and request for the
increased limit prior to loss event.
Increased costs of construction (a minor coverage in ISO property
policies) may not be enough if local ordinances have stringent requirements
regarding rebuilding damaged property. Exposure identification by way of
inadequate loss settlement post-loss event is not an efficient use of a
property risk management process.
Loss Scenario—A Hypothetical Look at Valuation Issues
Jones & Company manufactures electric motors that range in use from
residential swimming pool filters to running commercial heating and
ventilating systems. It has been in business for 50 years and operates out
of three facilities. Building 3, fully sprinklered, was constructed 10 years
ago specifically for Jones' manufacturing processes, utilizes
state-of-the-art machinery, and is approximately 20,000 square feet of
fire-resistive construction. Building 2, which is 10,000 square feet and
masonry construction, was acquired 15 years ago and was renovated several
times to accommodate expansion of Jones & Company electric motor products
and to extend the sprinkler system to all of the building.
Buildings 2 and 3 are located adjacent to one another in the same
industrial park. Building 1, located in an older and crowded area 2 miles
from the other buildings, is of old-mill construction (joisted masonry),
dates in part to the 1890s, is only 20 percent sprinklered, and is nearly
40,000 square feet. Jones & Company uses only half of that space, with the
remainder constituting a graveyard of old machinery and odds and ends.
Jones & Company is located in the U.S. Gulf of Mexico area. It did not
incur any damage from Hurricane Katrina, although many homes and businesses
in its geographic area are still feeling the effects of severe destruction
that took place only a few miles from the Jones & Company buildings.
Jones & Company's controller has insurance procurement responsibility, a
task he inherited by promotion several years ago when the chief financial
officer retired. Real and personal property values are increased an average
of 3 percent a year, although no one knows if the original baseline was
correct at that time or if it is current for purposes of the property policy
that renewed 2 months ago.
A few years ago, it was decided to change the valuation for Building 1
from replacement cost to actual cash value since senior management thought
it would never replace Building 1 if it was substantially damaged. A smaller
and more functional building would be built. The controller estimated
Building 1's actual cash value and believed the limit to be sufficient to
provide adequate funds to construct a much smaller replacement building that
would be perfect for current needs. The insurer responds to the change in
actual cash value by stating a lower specific limit for Building 1 and
changes the blanket limit to apply only to Buildings 2 and 3.
The change in valuation allowed the controller to decrease the
replacement cost building limit and reduce annual premium for Building 1 by
nearly 40 percent. The controller estimated replacement cost for a total
loss of Building 1 by averaging trended values for Buildings 2 and 3 since a
new Building 1 would likely be constructed in the same industrial park and
construction would likely be a combination of fire-resistive and masonry
non-combustible construction. It seemed like a logical and cost-effective
decision to change the valuation of loss.
Building 1 suffers a total loss from fire. Debris removal expense is
significant due to being in an older commercial neighborhood where buildings
essentially abut one another, making demolition and debris removal for Jones
both difficult and dangerous. Jones finds that its debris removal coverage
is part of the overall actual cash value limit and that the coverage is not
sufficient as provided in its standard ISO policy. Debris removal uses up a
significant portion of the building limit. While replacement cost and actual
cash value yield different building limits, the
actual cost of debris removal is not unaffected; it remains a cost
independent of whatever insurance limit or valuation applies to the building
The remaining building limit is less than 75 percent of what Jones
expected to receive as "actual cash value." The uninsured portion of debris
removal requires a six-figure payment out of Jones & Company's current
earnings, and means the company may run in the red for the remainder of its
fiscal year. There are no buildable sites that remain in the industrial
park. Two buildings are for sale, but upon close inspection, each will
require extensive renovations and cost to meet current building codes and
substantial renovations to meet Jones current manufacturing needs.
While the Jones & Company's property insurance policy includes "Increased
Costs of Construction Insurance" which would cover increased costs due to
building code changes, it applies only when the damaged building is subject
to replacement cost coverage. The need to meet current building codes will
increase the amount of uninsured loss borne by Jones and lead it further
into the red for the current fiscal year. Demand surge from post-Katrina
rebuilding has increased the cost of labor and materials in the local area,
which has increased overall construction costs and reduces the purchasing
power of the actual cash value settlement. Jones is forced to use its credit
lines to obtain financing for the uninsured portions of replacing Building
A post-loss insurance review was conducted by senior management to
understand how an insurance program described as broad and competitive could
be so inefficient when needed at time of loss. The board level report
included the following observations.
Major changes in insurance such as change from replacement cost
coverage to actual cash value should involve facilities and
manufacturing personnel. Input from these areas would have surfaced
issues related to available space in the industrial park as well as cost
of ordinance and renovation costs.
A tabletop discussion of a possible Building 1 total loss may have
resulted in concern for debris removal costs and the effect on the
remaining actual cash value limit.
A formal building appraisal every 5 years would have allowed Jones &
Company to better estimate values to set limits. The significant
increase in local construction costs may have been identified as well
and suggested use of trend factors for Buildings 1, 2, and 3 more than
the national trend factors of 2-3 percent.
There should be an annual review of property insurance coverage in
terms of current exposure, not just a summary discussion of renewal
terms, conditions, and premium. This type of review may have uncovered
the issues of increased costs of construction due to building codes and
effect of debris removal on policy limit.
Understanding the current value of a critical asset is of utmost
importance whether it is a building or a particular segment of contents.
Determining the correct value of an insured asset pre-loss will greatly
improve coverage and increase the potential for an insurance settlement that
truly puts the insured in the same position post-loss event that existed