Concern about underinsurance is nothing new. Limit adequacy is an important
issue in commercial property insurance—always has been and always will be. But
lately, industry professionals are expressing heightened concern about
underinsurance.
This concern about underinsurance is due to problems in the US economy over
the last couple of years.
Economic Problems Leading to Underinsurance
The onset of the COVID-19 pandemic in the spring of 2020 set forces in
motion that led to steep increases in the cost of construction materials, such
as lumber and steel, as well as labor shortages and supply chain issues. These
factors combined to raise the cost of repair and replacement of insured
property significantly, especially for damaged buildings. As a result, limits
of insurance on commercial property that presumably were adequate prior to the
pandemic were no longer adequate.
The problem of increases in insurable values during this time also applied
to business interruption values. Scarcity of materials, labor shortages, and
transportation and logistics problems lengthened the time needed to repair or
replace damaged property. Under these conditions, it might take 16 or 18 months
(or more) to rebuild and reequip a facility that could have been rebuilt and
reequipped in just 12 months prior to the pandemic. Since business income
limits of insurance are based on the estimated period of recovery, the result
was that previously adequate business income limits of insurance based on
shorter restoration periods were no longer adequate.
Documentation of the Problem
The reality of significant increases in the cost of replacing damaged
property was confirmed by the replacement cost value trend information from
valuation service companies and some major insurers in January 2022. For
example, Zurich North America's January 2022 Replacement Value Cost Trends report indicates a nearly 13
percent increase in the cost of replacing real property from January 2021 to
January 2022. This was a national average, with regional variation ranging from
10 to 15 percent. The overall average increase factor for the replacement of
personal property for the same period was 5 percent, with variation by industry
ranging from 1 to 10 percent.
Adding to the Problem: Inflation
Unfortunately, economic problems that affect insurable values have continued
in the first half of 2022. Inflation has been rising rapidly in recent months,
due in part to the war in Ukraine and big increases in energy prices,
especially gasoline. According to the US Bureau of Labor Statistics'
The Economics Daily article from June 14, 2022, "Consumer Prices Up 8.6 Percent over Year
Ended May 2022," the consumer price index increased 8.6 percent from
May 2021 to May 2022, which is the largest 12-month increase since the period
ending December 1981.
Addressing the Problem
Industry professionals are concerned that many businesses may have
overlooked the effect of the economic problems of the last few years on their
insurable values—and, correspondingly, on the adequacy of their property
insurance limits. For example, suppose a business used the same small
percentage increase that was appropriate in prior years (say, 2 percent) to
adjust their 2020 property value estimates for 2021—and then used that same
small percentage to arrive at insurable values for 2022. Suppose that business
also used the same estimated recovery period that they used in selecting their
2020 business income limits of insurance to select their 2022 business income
limits of insurance. That business is likely to be seriously underinsured—and
there probably are many such businesses.
What can be done? The first step is an awareness that the problem exists.
Agents and brokers need to tell their clients that their insurable property
value estimates and limits of insurance are likely to be too low and explain
why that is the case. Many agents and brokers are already doing just that.
Insurers also have an important role to play. Like agents and brokers, they
need to get the word out to their clients about the significant increases in
the cost of repair or replacement and the length of time it takes to complete
repairs.
The next step is for businesses to update their insurable values so that
they reflect the current conditions in the economy. Ideally, a business that
has not recently had its property appraised to determine its insurable value
would simply have a new insurable value appraisal done—right away. However,
that solution is probably not feasible for many businesses, especially given
the need for quick action to ensure that adequate limits of insurance are in
place. If having a new property appraisal is not practical, insureds can update
their insurable values and insurance limits using other methods.
Insurers May Be Able To Help
Insurers often are in a position to help their insureds arrive at realistic
insurable values and adequate limits of insurance. Since property underwriters
depend on adequate insurance to value when they establish rates and premiums,
they sometimes make their own rough estimates of the insurable value of their
clients' covered property. They may be willing to share their estimates
with their clients. In fact, some insurers may go even further and insist on
higher limits of insurance based on their estimates.
Alternatively, the insurer may be willing to share helpful valuation
information and tools so that insureds can use them to arrive at more accurate
estimated values. For example, the insurer may have access to a property
valuation service that provides square footage multipliers that vary by
geographic area and property occupancy. Another helpful tool that may be
available from the insurer is a schedule of index factors that can be applied
to original cost information for various types of property and industries. The
Zurich North America report mentioned earlier is an example of this.
Conclusion
If better information is not readily available, or as a temporary measure,
one possible approach would be to simply increase last year's estimated
insurable property values by a hefty percentage. In choosing that percentage,
keep in mind that the rate of inflation from May 2021 to May 2022 was 8.6
percent—and that does not include price increases from when the pandemic began
in the early spring of 2020 to May 2021. Also, don't forget about allowing
for a significantly longer period of recovery when selecting business income
insurance limits. Finally, once the insurable property value estimates and
limits of insurance have been increased to reflect current economic realities,
consideration should be given to activating the inflation guard option found in
standard commercial property policies. Once activated, the inflation guard
option increases the direct damage limit of insurance to which it applies by a
stipulated percentage—automatically and continuously throughout the policy
year.
Subscribers to IRMI's Commercial Property Insurance can learn
more about this very important topic by reading "Selecting Property
Insurance Limits and Deductibles: Determining Property Values" and
"Inflation Guard Optional Coverage in Building and Personal Property
Coverage Form."
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