Forecasters are expecting higher than average storm activity during the 2006 hurricane season. In addition, fire officials are warning that the Southwest and Great Plains could see a marked increase in wildfires this year because of persistent drought and above-normal temperatures.

Faced with these predictions, business owners throughout the United States need to make certain they have adequate property and business interruption insurance to protect their operations. Even businesses in areas not prone to natural disasters should be concerned about purchasing proper insurance limits. For example, a relatively small fire causing damage to a key production line in a manufacturing plant can result in a significant amount of downtime.

Recovery costs could far exceed what was anticipated when critical machinery and spare parts are not available or slow in arriving. Insurance carriers can work with their commercial clients to help them determine the true value of their property and the nature and scope of their business interruption exposures. This way they can secure the appropriate amount of insurance and get their operations back online as quickly as possible.

Commercial properties are routinely undervalued. Some business owners, agents and brokers base a property's value on "book" value, not on the cost to replace the structure, which can be much higher. Book value can mean different things, such as market value at acquisition of the asset, depreciated value, or some form of trade or wholesale amount.

In addition, as the cost of energy continues to rise, overall expenses will rise, driving up costs for building materials, transportation and labor. The fact is the actual cost to rebuild or repair a building or replace equipment can be far greater than the property's book value.

Although blanket limits of insurance and policy contracts written without a coinsurance penalty may allow some losses to be adequately protected against, they are not a substitute for accurate and adequate valuation.

In situations where valuation is determined to be inadequate, an insurance carrier may be less willing to write the account or provide broad insuring terms. In such cases, the policy contract may be scheduled with specific limits for each location and for each subject of insurance. Simply speaking, insureds should strive for insurance value to be certain they can recover 100 percent of their loss.

Clients may fail to understand the difference between market value and building replacement cost. An insurer may conclude that $10 million is an adequate replacement cost for a manufacturing plant, but the client may insist the figure is too high considering the $6 million sale price for a similar building down the street.

Depending on market conditions and availability, it's sometimes possible to buy an existing building for considerably less than the cost to construct a new one. Those business owners who want to rebuild at the same location must realize the decision may add to their costs. The reverse can be true as well. Market value in a rising market can outpace the cost to reconstruct, which could lead to overinsuring and potentially paying too much premium.

Consider, too, that on a square-footage basis, a partial loss can be more expensive than replacing an entire building. Often, in a partial loss, there are extra costs for bringing a building up to code, and these are not necessarily factored in by clients when estimating the replacement cost figure.

For example, if the damaged portion of a plant was not protected by automatic sprinklers, the company may have to install a sprinkler system to meet local ordinances. Another example would be that a community's recent revision of seismic codes may force an owner to replace a damaged wood joist building with a more substantial structure.

Labor costs to rebuild on short notice will likely exceed labor costs for new construction that is planned months in advance. This is true for both partial and full losses, and would be exacerbated if the loss was due to an event that affected a wide area.

The cost of raw materials has recently increased tremendously because of the demand by countries with growing economies and geographic regions rebuilding from catastrophes. This trend may vary, but there have been growing shortages of certain types of materials and longer lead times for construction. These, in turn, have driven up the price of construction as well as the business income exposure.

Over the past two years alone, the cost of lumber has risen 21 percent; drywall, 29 percent; copper pipe, 27 percent; structural steel, 53 percent; and steel studs, 78 percent, according to Marshall & Swift/Boeckh, a supplier of building cost data and valuation tools.

On a national average, construction cost increases have consistently outpaced inflation, with a hike of 16.8 percent from March 2002 to March 2005, the company reported.

Clients also have difficulty pinpointing repair or replacement costs for various types of machinery equipment. Generally, they carry these items at book value, which is a depreciated value. Some equipment may be custom-designed, making it hard to fix a price, and some may not be available new without paying for additional capacity or features. Equipment may even be obsolete and unavailable. Thus, the client may have to choose a more sophisticated model or another piece of equipment that performs a similar function but is configured differently and costs more.

As difficult as valuing building and equipment can be, business owners can be even more unrealistic in estimating the cost and duration of a business interruption. In fact, evaluation and identification of the exposure and the controls necessary to mitigate the potential for a loss can be a significant engineering feat.

Insurance carriers can assist their clients in determining their business interruption exposures, but businesses still must take the lead and spend the time to determine the exact extent of these exposures. Often, insureds will confidently project an interruption of only three-to-six months.

What they don't take into account are the many obstacles that damage to buildings or machinery can present. If they lack critical spare parts on site or don't have other backups readily obtainable, the downtime can be far more significant than anticipated.

If a business has a single location that is hit by a major fire, it may be fairly easy to predict how long it will take to restore operations.

In the case of a regional disaster--post-hurricane New Orleans is a prime example--where thousands of businesses and residences may be affected, building materials and labor may become scarce and the demand so great that a business owner may not be able to get a contractor to his site in a timely fashion. Also, firms dependent on a major supplier or a major customer risk losing all control over the situation if the supplier or customer encounters a significant business interruption.

With many unknowns, the best way to arrive at an accurate commercial property valuation for building is through an appraisal. Since book value may or may not correlate closely to what the replacement cost is, understanding the cost of construction is key. Business owners usually don't have expertise to determine this, but their broker or insurance company does and can provide appraisals on building and business interruption values.

As for contents and equipment, there's no precise way of determining replacement cost unless it's done on an item-by-item basis. A first step would be to contact the manufacturer and discuss the current replacement values of the equipment. Used equipment markets should be checked to review the availability of equipment of like kind and quality. It's also helpful to consider the availability of critical spare parts.

From a business interruption standpoint, clients should evaluate their vulnerability to various types of losses and formulate a disaster recovery plan. In the case of custom-designed or obsolete equipment, they should create a spare-parts reserve, thus eliminating or reducing the downtime of equipment and processes.

Insurance carriers, agents and brokers can work with their commercial clients to help them determine the true replacement value of their buildings and equipment and the nature and scope of their business interruption exposures. If both the insurer and the customer agree with property valuation, potential claims disputes can be averted. Failing to understand true property value, however, can prove costly for businesses as they struggle to resume operations after a significant loss.

Special Reports /

Accurate Property Valuation Key To Effective Contracts

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