Valuations: Educating Your Client on True Replacement Cost
There are two calls that an agent or broker might receive that should raise concerns; the first is a call from the IRS audit department and the other is from an insured who says, “I just had a fire.” The reason the first call is a concern is obvious, but why be concerned with the second call? Your biggest exposure to a lawsuit is from an insured that has improperly written coverage and suffers a co-insurance penalty because of it.
The most common cause of this kind of problem is failing to understand what the insured needs before a loss occurs or otherwise stated as under-valuation in coverage. Why does this happen? The answer is not simple. There are many causes of under-valuation when writing coverage. One of the most common reasons is failure to ask the proper questions as to what the insured needs to cover property and avoid co-insurance. Another is failing to ask the appropriate follow up questions when an insured states their value needs. There are tips you can learn to help reduce the risk of under-valuing coverage or at a minimum prepare yourself to defend an action if a client should name you in a suit.
The question asked of every insured is, “What are the values of your building, personal property and business income needs?” The answer you get may not be the one you are looking for. Let’s first look at the definition in the policy of replacement cost. It is defined as today’s cost to replace the structure with like kind and quality material.
Now let’s consider a commercial building. When the answer to the inquiry is provided, can you truly rely on that answer? I suggest that you cannot. What value did they give you? Was it based on a purchase price or perhaps an appraisal of the property? Maybe the value provided was the actual cost the insured paid to build the structure. There are the problems in each instance.
Purchase price: There is no correlation of purchase price to construction cost. In the purchase price factors such as land value, income produced by the property or condition of the improvements (age) are all considered.
Appraisals: These opinions are usually produced for bank loans or other reasons not related to construction costs. They usually include the cost of land and factor income in as well. One must be very careful if basing a coverage amount on a real estate appraisal. If you are using an appraisal number, be sure you or your client understands what the appraisal was made for and based on. One must consider how up to date the appraisal is, as well, if it passes the test of applicability.
Building cost: This may be your best guide to ascertaining value but beware of the following concern. When was the building built? The value must be current if it is to be used. You should be familiar with what has happened to the construction costs in your area since the building was built, especially if there was a natural disaster recently that causes huge increases in material costs.
Was this built as a part of a big construction project such as multiple buildings being constructed as a residential construction development? If so, would the builder rebuild again for the same price? What code and ordinance changes will be needed since the building was built? All of the sources of value above would also add the value of below ground foundations that do not need to be considered in values. What needs to be considered are attachments to the buildings such as signs or lighting, external structures like sheds and attached garages and of course Tenant Improvements and Betterments (TIBs). You must review the lease to see who has the insurable interest in them. Keep in mind that the ownership of TIBs changes with every year that goes buy in most lease agreements.
These are the considerations on buildings. You must understand which value your insured is stating before you write the coverage. If it falls into one of the above categories you need to do some more work. Perhaps ask the appraiser to revalue the appraisal to construction costs only, excluding land and other non-insured costs. Perhaps have the insured go back to the contractor (or the insured’s sub-contractors if doing the project themselves) to update costs to today’s value.
Lastly, if allowed, you can use the valuation programs that the companies supply to determine building value, however in California the use of these type of programs are now being discussed and regulated by the DOI and may not be available. One advantage to this type of valuation system is that the responsibility of under-valuation can be shifted back to the carrier if it is the carrier’s program that determines the value and those values are wrong!
A look at personal property coverage will have issues similar to the building coverage. When an insured provides their personal property values, you must now follow-up and inquire as to how they came up with those values. What are they reporting as the value? If it is stock, the insurable value of the stock is their cost to replace today, including shipping (transportation) costs, shelving and handling. It is not sales price or book value. Personal property values must also include cost of fixtures, equipment, office supplies, desks, stationary, packaging and shipping material, etc. Any other non-attached items in the building must be considered as BPP, such as trade fixtures, gondolas and the like. Many people overlook these areas and the values can add up quickly causing a co-insurance or under-insurance problem.
Above, I mentioned book value. You absolutely cannot base values for real or personal property on P&L statements or financial statements, which list assets owned by the company. These values are all depreciated for tax purposes and are not representative of today’s values.
So how can you be sure you are writing the proper coverage? First, educate your client as to what you are looking for on values. Most insureds know the value of stock. They can go to vendors for help in determining cost of fixtures and equipment. There are appraisers who can value equipment, build-outs and fixtures if needed.
If the business has multiple locations it is best to write on a blanket coverage basis. This will allow you to get the needed coverage from other locations if you are short of coverage at a location that suffers a loss. This also works for buildings as well. Agreed value coverage can avoid co-insurance problems but still may leave the client under-insured and not made whole due to a loss.
Business interruption coverage is similar to personal property coverage in some cases; there are only a few areas to consider but it is harder to determine due to the nature of coverage. The first thing to consider is what is being insured. Is it last year’s income or a projection of what is to be? We must look to last year’s income but also consider what the projection of income is expected to be in the next 12 months. Are they including ordinary payroll in their calculation? What you must ask your client to consider is whether or not they will continue payroll in a total shut down or terminate some or all employees. If the answer is they will keep their employees on payroll then you must include the cost in your income work-up. If, on the other hand they will let some or all employees go during the rebuild you may eliminate the cost of payroll
completely.
What will they do in the event of a major loss? Will they relocate or shut down? Will they go to outside sources for products, which increases their cost of goods sold? If the answer points toward big extra expenses or expediting costs, consider writing additional extra expense coverage for this. Do not forget to add an Extended Period Endorsement (which pays the cost in 30-day increments after the end of the suspension period to cover the shortfall in income while a business recovers from a loss).
Many companies you write for have programs or templates you can use to determine income coverage needs. You should consult, when possible, with your client’s accountant (not bookkeeper) for help in determining values and needs for the upcoming year. Also today’s major losses take close to a year to settle and rebuild so less than one-year’s coverage is not recommended.
Depending on the answer you get, there are various directions you can take in your follow-up questions. Keep in mind that an insured that understands the importance of proper values and what you are really looking for will give more thought to their answers and help you write the best coverage you can. My experience as a public adjuster who represents the insured’s interest in claims has taught me that an insured that has suffered a loss and seen the effect of co-insurance issues never again underestimates their values. If you can educate your client on the importance of proper values before they suffer a loss you may not lose a client because of an unhappy claims experience, or avoid costly litigation.
After you have the above conversations with your insured and agree on values you must confirm your discussion of all conversations in writing. As a final thought you can consult with a reputable public adjuster in your area for help in determining values. Larger firms would be happy to discuss this with you before a loss occurs, and we make it a practice to go with the agent/broker when requested to visit the insured and discuss
their needs.
Robb Greenspan is principal
of California-based The Greenspan Co./Adjusters International. He can
be reached via e-mail at robb@greenspan.com.