Underwrite, Don't Undervalue Property

It is hurricane season, and there is no better time for our industry to rededicate itself to the basic underwriting principle of Insurance to Value.

Lessons learned from past catastrophes show that foregoing ITV homework can be very risky business. The task is all the more difficult in a troubled real estate market amid hotly competitive insurance conditions, yet it's a must.

First, a quick refresher on what ITV is, and is not. ITV is the ratio of the amount of insurance to the value of the insured property risk. It is not to be confused with the insurance limit, which is the amount of insurance the underwriter contractually agrees to provide in the event of a covered loss. Values and limits are different concepts, with different purposes (although interrelated) in property underwriting.

Consider a 10,000-square-foot building with a replacement cost value of $1 million, or $100 per square foot. The policy may have been written several years ago when the value of the building was $750,000, or $75 per square foot. If ITV was not reconsidered each year, and construction costs have risen (virtually a given), the premium would be based on $750,000 for a $1 million building.

This creates a number of issues for the insured and the insurer. The insured may be carrying less insurance than is necessary for total replacement of the building, while the insurer would not be receiving adequate premium for its exposure. In fact, insurers may not even recognize their exposure is greater than they believe they are insuring.

Too often in the underwriting process, ITV is given a cursory glance and carried on from year to year on the insurance application. The temptation to do this is obvious. Among its many applications in the underwriting process, ITV is used to illuminate the size of the insurer's exposure and hence the rating base.

Higher ITV means higher premium. As difficult as it is to be the bearer of a premium increase (particularly if it is perceived to be bucking the trend of a softening insurance market), rates must be tuned to accurate values. When they are not, both policyholders and underwriters are at risk.

IN HARM'S WAY

Placing coverage with an artificially low ITV is akin to underestimating receipts on a liability risk. A client today will no doubt be pleased to see premium stay flat, or better yet, decline. However, if the risk is not insured to adequate value, the policyholder is sure to be handed costly problems, such as underinsured losses or loss adjustment complications (e.g., litigation), down the road when a loss occurs. Coinsurance penalties can also apply.

Inadequate ITV has adverse consequences for carriers as well. When an individual risk is undervalued, it can present coverage issues if blanket insurance and agreed-amount coverages are provided. As undervalued risks accumulate within a carrier's portfolio, the resultant rates will be inadequate. Additionally, if a portfolio is undervalued, there can be detrimental consequences for probabilistic modeled results and reinsurance programs and insufficient funding for catastrophe claims.

While the problem is one no property carrier can ignore, it is particularly acute for insurers writing catastrophe-exposed risks, whether it be Florida wind or California earthquake. Catastrophe insurers generally use computer modeling to keep watch over accumulations of exposures. Modeling is also deployed at the desktop level to sharpen on-the-spot risk selection and pricing of individual risks. When inadequate values go into these models, inaccurate results come out.

The gap between the actual and proper values can be stretched further still in the wake of catastrophe losses, when “demand surge” and stringent building codes can dramatically drive up the rebuild cost per square foot.

So what are already overworked brokers and underwriters to do?

Everyone is pressured to produce, and no one wants to have “the conversation” about raising values. Selling a premium increase is never easy. It is harder still in an environment where insurance budgets are stretched thin and insureds are seeing real estate market values plummet.

GETTING THE WORD OUT

Yet, have those conversations we must. Properties are not insured to real estate market value, but to replacement cost or actual cash value, which largely (at minimum) stays the course with inflation. It's our job as an industry to help policyholders understand this–and understand the true cost of not insuring to value.

Sure, the broking and underwriting process will take a little longer, even with today's desktop ITV programs. But when scheduled values are assessed yearly, income statements are reviewed annually for business income amounts, and underwriters are proactive in attesting to the accuracy of values, then insurance companies maintain adequate exposures and a proper rating base. Policyholders get sound protection, at sustainable rates.

Getting ITV right is more important than ever today. Because ITV values do not correlate to the values of the beleaguered real estate market–and the wind is blowing.

Stephen Nadeau is underwriting manager of commercial property E&S division of Beazley Group in Boston. He can be reached at stephen.nadeau@beazley.com