Policyholder Pulse
Earlier in 2022, CBRE forecasted a 14.1% year-over-year increase in construction costs by year-end 2022, as labor and material costs continue to rise, despite the expectation that overall cost inflation for materials would begin to cool by the end of the year. Commercial construction costs have indeed increased, as Turner Construction Company’s Third Quarter 2022 Building Cost Index reported an 8.62% yearly increase from the third quarter of 2021, a 2.18% quarterly increase from the second quarter of 2022. In addition to supply chain issues for building materials, skilled labor shortages and construction wage growth persists.
Despite commercial real estate prices decreasing 13% in 2022, commercial property insurance premiums rose an average of 11.2% in the third quarter of 2022, compared to 8.3% in the second quarter, largely driven by inflation, according to the Council of Insurance Agents and Brokers (CIAB). Inflation increased construction costs, which has led to increased property valuations. Increased construction and replacement costs resulted in underwriters requiring higher property valuations when writing or renewing coverage, which in turn increased premiums to cover the higher exposure from the increased value of the property.
The Importance of Updating Building Values
Whether commercial property values have increased or decreased, policyholders face the risk of significant gaps between commercial property market values and replacement costs. The values stated in an insurance policy may not be enough to cover replacement costs at today’s prices if a major loss occurs. As replacement costs fluctuate based on market trends and broader inflationary pressures, it is critical to regularly reassess the current value of commercial buildings.
Insurance to value (ITV) is an assessment of the complete cost to replace or restore insured property which is a critical element of a comprehensive property insurance program. A policyholder could face a number of ramifications if it conducts inaccurate ITV calculations and undervalues its properties. Because the cost of building materials and labor has escalated so steeply over the last year, many commercial properties may be difficult to reconstruct for the values stated on their insurance policies. As a result, businesses may lack sufficient coverage following property losses, forcing them to pay out-of-pocket expenses in order to fully rebuild. Depending on the severity of property losses and associated rebuilding operations, paying these costs out of pocket could require reconstruction using cheaper materials, or lead to major financial setbacks, even bankruptcy.
Additionally, property undervaluation can sometimes result in coinsurance penalties as many commercial property insurance policies include coinsurance clauses, which encourage policyholders to carry certain specified amounts of coverage. Under a coinsurance clause, a policyholder may be subject to a penalty—generally, a reduced payout—if its coverage limit is not at least equal to a predetermined percentage of the value of their property. A coinsurance penalty limits the amount recoverable following a loss.
When purchasing or renewing commercial property insurance, policyholders should ensure that such coverage includes correct property valuations. Doing so can make a significant difference in providing sufficient protection and preventing coinsurance penalties amid covered property losses. Conducting accurate ITV calculations can be important to avoid any pitfalls. An estimated 40% of businesses do not reopen following a major disaster and another 25% fail within one year according to the Federal Emergency Management Agency (FEMA). Each year disasters such as floods, hurricanes, tornadoes and wildfires force thousands of businesses to close. But even more common events, such as building fires, cause the same result.
Policyholders should review their policies regularly, and make updates as needed, including working with their brokers to either eliminate coinsurance requirements or make sure the coinsurance amount is reasonable. Because the value of a commercial property often changes, it is imperative to update property valuations on a regular basis. Appraisals should be prepared at least every three to five years. Take note that property valuations may need to occur even more often. The frequency will depend on factors such as changing property exposures, altered operations, building upgrades or modifications, the implementation of new technology or equipment on-site, shifting market conditions and property construction trends such as today’s inflated labor and material costs. Ultimately, correct property valuations are critical in securing adequate commercial property insurance which can help a business stay protected when covered events occur and avoid potential coinsurance penalties.
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