Underinsurance – a false economy

Continued inflationary pressure and lengthening build periods demand that those with responsibility for managing property insurance review:

  • Building Reinstatement Valuations (BRVs)
  • Indemnity periods, relating to loss of rent
  • Inflationary uplift provision

The impact of underinsurance

Underestimating any of the above figures creates a direct exposure to the owner’s balance sheet and, in some instances a potential breach of the requirements of leases and/or lending covenants. Ensuring a building is insured for the correct sum can also, following damage, help to minimise delays during the re-build period which should mitigate against the loss of tenants and reputational damage.

The impact of underinsurance, in the event of damage, may be more keenly felt where the insurance relates to either a small portfolio or a single asset which benefits less from any policy wide sum insured provision that is beneficial for larger portfolios.

It is probable that increasing the TIV will result in a higher insurance premium spend but the additional cost is likely to be immaterial when compared with the impact of underinsurance on a balance sheet, in the event of major damage to an asset.

Building Reinstatement Valuations

The material price index for ‘All Work’ increased by 24.1% in June 2022 compared to the same month in 2021i. The impact of inflation which is predicted to continue rising well into 2023 does not just affect materials’ costs; it affects most components of re-build including demolition costs and professional fees.

Index linking is typically applied to reinstatement valuations to ensure they remain broadly in line with inflation. It is tempting to think that if the valuation was correct when it was undertaken, applying index linking annually thereafter should ensure the valuation remains correct. This is not always the case because index linking applies to an ‘average’ building failing to take account of the fundamental differences that are specific to each building. The rate of indexation for the reinstatement of a simple logistics unit would likely attract a very different uplift to the reinstatement of a complex medium to high rise grade A office building in a city centre location.

If a building is underinsured, insurers can apply the Average clause, which reduces the settlement in the event of a claim, in direct proportion to the degree of underinsurance. By way of an example, if a declared value reported is 50% less than the correct figure as at the first day of the insurance period, insurers have the right to reduce the settlement amount of any claim by 50%. This does not just apply to a total loss it also applies to smaller claims.

Typically, insurers waive the right to apply the condition of Average if BRVs are obtained not less frequently than once every three years, with the declared values being adjusted accordingly and adjusted for inflation in interceding years. However, it is important to note that that this does not increase the insurers overall limit of liability which will remain capped at the value declared for the buildings.

Indemnity Period

In the context of property insurance, the maximum Indemnity Period is the maximum period during which insurers will cover the loss of rent arising from the building suffering insured Damage. The longer the maximum indemnity period selected, the more costly the insurance but underestimating the reinstatement and re-letting period can leave an owner exposed to an inadequate rent settlement.

Factors such as size of the building, complexity of construction, neighbouring buildings and Listed status should all be considered when setting the Indemnity Period. Supply chain and workforce shortages should also be taken account of as these will naturally have an impact on the time required to reinstate.

Andrew Hudson, JLL “We would definitely advocate for the consideration of longer demolition and re-build periods as labour and material shortages, procurement challenges and increasing regulation can all bring delays, that can prove challenging to resolve successfully and swiftly.”

Inflationary Uplift

The normal approach to insuring buildings in the UK is that the policyholder declares to the insurer the replacement cost of the building on day one of the policy period. This figure excludes any allowance for the impact of inflation over the term of the insurance policy, and any subsequent rebuilding period following damage, because the policy will include a separate provision for inflation. This provision has historically provided an uplift of up to 50% on the day one replacement cost. However, in the past two years, insurers have been attempting to reduce it to a much lower level – in some cases as little as 15%.

Given current inflationary pressures, reductions in the uplift provision must be carefully reviewed and where necessary, pushed back on to avoid a potential shortfall in insurance proceeds. For example, if a building undergoes significant damage eleven months into the insurance policy, and then takes 3 years to reinstate, nearly four years of inflation may have been incurred on the declared value originally reported. This might not be an issue in a stable economy, but the volatility experienced recently could make inflationary provisions of 15% look significantly inadequate.

Allow your Broker longer to negotiate with insurers

Property insurers will have a limit on how much property they can underwrite in a specific geographical postcode. This controls exposure to the losses arising from a major catastrophe resulting in damage to multiple buildings for example, a terror attack or gas explosion. Those limits can be quickly exhausted in City Centre locations where assets with higher TIVs are often more densely populated.

As TIVs increase, insurance brokers may need to involve multiple insurers to secure cover to the TIV of the building. Programmes that historically may have had one insurer could now require three or four. As a result, Insurance Brokers will need longer to negotiate with insurers, if they are to secure the most favourable terms.

The Cost Mangers view

Andrew Hudson, Head of Cost Management at JLL has undertaken hundreds of BRVs throughout the world working with a host of private and public sector clients on globally recognised properties and portfolios.

  • BRVs should be provided by Quantity Surveyors who are actively involved in project delivery. They will be more familiar with construction costs than Valuers and they will have an up to date understanding of material and labour costs.
  • You should ideally use a provider with both specialist knowledge of the asset class and a familiarity with the area where the asset is located.
  • It is not recommended to secure a desktop BRV unless the firm you are employing has previously inspected the property and, only then, if the property hasn’t undergone significant work in the intervening period.
  • Getting properties within close proximity to one another assessed at the same time can reduce cost.
  • If the building is severely damaged, will it be demolished or re-constructed? What impact will the planned approach have on the funds required to reinstate?
  • Check the allowance for professional fees e.g., design costs. These are often routinely set at 15% which may be insufficient for a complex building and/or fail to take account of inflationary pressure on fees. It may also be vastly more than that required for a simple development.
  • BRVs must take account of what surrounds the building. It is, for example, likely to be more costly to reinstate a building in a densely developed location where a Party Wall is shared with a Listed Asset. Leading on from this be wary of BRVs that contain either excessive or minimal assumptions.
  • BRVs typically track the material prices indices but there are situations where construction costs can come under localised, upward pressure for example where naturally occurring extreme weather events, such as wildfire can damage multiple buildings in a geographically large area resulting in a sudden and very localised surge in demand for material and/or labour. The Inflationary Uplift clause should make provision for this, but this further underlines the importance of ensuring the provision remains at closer to 50% than 15%.