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 important topic by reading the following sections.
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.
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 important topic by reading the following sections.
Vertafore ReferenceConnect Subscribers
IRMI Online Subscribers
Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.