Working with your broker to reflect current property values is essential. Without accurate appraisals, many cities are experiencing increased premiums and forced changes in coverage, limits or deductibles.

Authors: Larissa J. Gallagher Michael Burg

Valuation and appraisals

What is the typical "Replacement Cost" valuation basis for real property and personal property?

Real property (buildings): On buildings and structures — replacement cost new with materials of like kind and quality.

Personal property: On machinery, equipment, furniture, fixtures and improvements and betterments — replacement cost new with materials of like kind and quality.

"Replacement cost new" should include the cost to ship replacement equipment/parts to your facility, which can be a high cost for large, heavy machinery and/or if it's coming from overseas. The cost of any professional installation and testing required should also be included.

Valuation adequacy and claims inflation

The topic of "valuation adequacy" has been simmering below the surface for a number of years, but went largely unaddressed during the soft market cycle for 10 years prior to 2017. While some insured's diligently applied the most recent indexing factors and/or obtained appraisals on a rotational basis in an effort to maintain current "replacement cost" valuation, many ignored the issue and recycled old valuations across multiple renewals, which got them further away from adequate valuation each year.

FM Global published their biannual cost index report at the beginning of the year, showing an overall average annual inflation index (January 2022 v January 2021) of 18% for real property and 7% for machinery and equipment, as well as 30% for some specialty engineering equipment. Various qualified, third-party valuation and appraisal firms (Marshall & Swift, Duff & Phelps, CBIZ, Stout, Gallagher Bassett and others) have also released reports during the past several months that support similar levels of inflation to the index factors offered by FM Global.

Post-pandemic inflation is driving reconstruction costs and increasing claims due to high consumer goods demand and supply chain disruption. The increase in cost and availability of construction materials is causing insurer's claims costs to soar and increase industry focus on valuation. "Valuation adequacy" has become the #1 focus for most insurers in 2022.

In addition to the cost and availability of materials, increased labor costs and sparse contractor availability are also driving higher overall replacement cost of facilities. Insurers have been experiencing firsthand a widening in the gap between the actual cost to rebuild in the claims they are paying, versus the values reported by many Insureds on their statement of values (SOV).

Insureds should discuss purchasing replacement cost appraisals with their brokers, to ensure valuation adequacy for both buildings, and machinery and equipment. For large facilities, the cost to do so may be less than applying a standard 18% inflation factor to insured's property values, at the same premium rate. For many manufacturing clients, the inadequacy of machinery and equipment values is often equal to, if not more understated than, the building values.

Examples of client appraisals completed in Q3 of 2021

Prior to Appraisal Appraisal Valuation
Occupancy Number of Locations Appraised Combined Square Footage Combined Buildings Value Combined M&E Value Combined Buildings Value Combined M&E Value Building Difference % M&E Difference % Appraised Building Cost Per Sq. Ft. Average
Food Manufacturer 4 867,075 $68,277,210 $163,100,000 $116,931,000 $350,081,000 71% 115% $134.86
Food Manufacturer 10 1,047,809 $111,865,040 $141,960,000 $141,960,000 $202,909,553 27% 24% $135.48
Chemical Manufacturer 9 1,618,640 $107,800,000 $183,661,278 $183,661,278 $65,217,217 70% 39% $113.47
Note: The appraisals for the three clients listed above were completed by three different appraisal companies.

Appraisal outcomes on insurance programs and consequences

Insureds are often concerned that completing appraisals or indexing values will have a significant detrimental outcome on their property insurance cost. This is often not the case, and there can be significant consequences for not maintaining adequate valuation.

In many cases, insurance companies are already loading their rate and/or restricting coverage when they believe values are underreported. For two of the three examples in the appraisal example above, the client's 2021 property renewal following the appraisals resulted in a 30%+ rate reduction, when the market average was still a 10%+ rate increase. Insurers are willing to reward clients for "right-sizing" their values.

For insureds with reported values below present day "replacement cost" valuation, we are seeing greater pressure from underwriters to utilize coverage-restricting tools available to them. Such tools include: margin clauses; "occurrence limitation of liability" or "maximum amount subject" clauses — which tie maximum amount payable in the event of a claim to the values reported on the SOV — effectively voiding blanket policy limits; or even Coinsurance Clauses to protect the capacity that the insurer is deploying.

The best way to avoid having any of these coverage restrictions on your policy, is to demonstrate to your insurer(s) that the values being reported are adequate, and that a consistent "valuation methodology" is being used to calculate/inflate your values at each renewal.

Property loss control engineering

Underwriters continue to apply pressure on insureds to bolster their property loss control engineering program, and create "risk improvement plans" to provide a level of commitment to the Insurer that, at a minimum, critical and important recommendations including those requiring capital expenditure (CapEx), will be completed in a reasonable time frame. For insureds that plan to market their risk in the next 12-24 months, it is strongly recommended that third-party property loss control engineering reports are purchased, if not already being provided by the insured's insurance company.

There continues to be a wide range in the quality and quantity of report content provided by different insurance carriers, and some are simply inadequate for an effective marketing exercise.

Insured's often ask how much "premium credit" is available for completing certain CapEx recommendations, and unfortunately, this is a loaded question, without a straightforward answer. During the soft market cycle of 2007-2017, there were instances of insurers providing specified credits for compliance with specific recommendations. Today, such instances are rare. As deductibles have increased in recent years, insureds have more "skin in the game" than ever before, so protecting their facilities against loss is also protecting their balance sheet from the cost of deductibles. Insurers consider improvements completed and the associated overall impact to the insured's account risk score, rather than on an individual recommendation or location basis.

Since late 2017 and through the recent hard market cycle, the conversation has shifted from "how much credit can I get?" to "what are the consequences going to be if I don't?" We have seen many insured's get non-renewed by their insurers because of a track record of ignoring recommendations, and in the majority of these instances, replacement programs have come at significant additional premium cost as well as with reductions in the overall policy limit and/or with reduction in coverages and increased deductibles.

It is recommended that insured's have a stewardship meeting with their property insurer's underwriter and account engineer at least annually to review and prioritize recommendations, and ensure all parties are in agreement to a reasonable action plan for completion. It is often not realistic to accomplish everything in one year, but a level of progress and continuous improvement should be evidenced at each renewal.

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