The risks of underinsurance for commercial property owners
Understanding underinsurance and co-insurance
Underinsurance can lead to serious financial implications for commercial property owners. Where insured values have been underdeclared it is possible that claim entitlements will be reduced in direct proportion to the level that the values have been underdeclared. This reduction in cover is the application of “co-insurance” and it is critical policyholders understand how co-insurance clauses operate, as well as review their current insured values, to ensure their assets are adequately covered. Significant increases to construction costs and timeframes in the current market have made accurately declaring insured values more challenging and exacerbated the risk of co-insurance for property owners.[1]
Whilst co-insurance can operate to penalise policyholders, it is important to remember co-insurance clauses give some leeway to policyholders in setting and maintaining insured values. Ultimately, it is the policyholder’s responsibility to report accurate insured values and we therefore recommend reviewing insured values and seeking independent valuations annually, or on a rolling basis within a valuation programme.
Business Package or ISR Mark IV Wordings
The two main commercial property policy wordings we will focus on are the Mark IV Industrial Special Risks (ISR) policy wording (suited to large property programmes with insured values typically being more than $10M) and “Business Package” policy wordings (designed for smaller asset values and can be tailored to include multiple policy classes, such as Property and Public & Products Liability, under the one policy).
Property cover under Business Package policies is narrower than that provided under ISR policies in that it is a defined perils policy, whereas ISR policies provide cover on an all-perils basis. This simply means that a Business Package policy specifically defines events that can trigger the policy and then also applies exclusions. The ISR policy covers all damage to insured property unless an exclusion applies.
There is very little difference between the scope of co-insurance clauses as between Business Package and ISR Mark IV wordings. We typically see more leeway being given under Business Package policies for the levels of underinsurance that are allowed before co-insurance applies.
Co-Insurance Clauses
The following is a co-insurance clause from a standard Business Package policy wording:
Underinsurance/loss or damage
In the event of loss or damage to Property Insured under this cover section for claims settled on a reinstatement or replacement basis, We will not be liable for more than that proportion of damage which, in respect of Buildings, Contents, Stock and Specified Items the Sum Insured on the total amount for Buildings, Contents, Stock and Specified Items at the Premises, at the time of the commencement of each Period of Cover bears to eighty percent (80%) of the full insurance value of such Buildings, Contents, Stock and Specified Items.
Conditions
Our liability is limited to the Sum Insured at the Premises as shown in the Schedule.
This clause will not apply if the amount of any damage does not exceed ten percent (10%) of the Sum Insured at the Premises.
Example
Total reinstatement value $200,000
80% of value = $160,000
Sum Insured = $144,000
Therefore is a $100,000 loss occurred, We would pay ($144,000/$160,000) x $100,000 = $90,000.
We would pay $90,000.
Any additional costs incurred to comply with the requirements of any statutory authority, by-laws or regulations shall be omitted from the calculation or Our proportion.
- It is important to review the wording to determine whether the co-insurance clause relates to declaration of insured values at specific locations or the insured values of multiple locations combined under a broader programme. It is far more common to see the requirement apply in respect of every location under a program and that is the case in this example.
- We must stress that the co-insurance threshold, in this case 80% of the actual reinstatement values, is not the target figure when declaring insured values. Property owners should seek to declare the full reinstatement values. Under most ISR Mark IV policies in the current market the requirement is slightly more onerous at 85%.
- If the loss does not exceed 10% of the declared total insured values for the location then co-insurance does not apply. Under most ISV Mark IV policies in the current market, the requirement is slightly less lenient at 5%.
- The policy commencement date is the reference point for assessing the declared insured values against actual reinstatement cost, not the date of the loss. However, to be prudent, policyholders should consider setting the insured values to the cost of reinstatement at the end of the policy period as inflation means that the risk of surpassing the minimum claim threshold has increased over the course of the policy period.
- It is common for the costs of complying with added statutory and licensing obligations relating to the reinstatement to be excluded from the calculations.
One variation we do see is additional leniency where it can be demonstrated the policyholder has obtained independent valuations and kept insured values in line with the progressive annual uplift rates stated in the valuation. The following is an example from a Business Package policy wording of a writeback to co-insurance where the policyholder has current independent valuations and we note that similar writebacks can be included under ISR Mark IV policies by way of endorsement:
2. this clause will not apply if:
(i) the amount of any damage does not exceed 10% of the sum insured at the premises.
(ii) to property forming part of the property insured which has been insured under this Policy for the full value stated in a valuation prepared by an approved valuer not less than three years before the commencement of the period of insurance, and which an approved valuer has updated not more than twelve months prior to the commencement of the period of insurance. ‘Approved valuer’ means a certified practising valuer registered with the Australian Property Institute within the relevant property discipline.
It is important that any independent valuation is specifically prepared for the purpose of assessing the insurance reinstatement costs. Valuations undertaken for purposes other than insurance can include additional factors, such as land value, or exclude financiers. Insurers will have different considerations and purposes in requiring property valuations so it is important the valuation address Insurance Replacement Cost Assessment.
It is possible to endorse policies to void co-insurance where independent valuations are undertaken on a rolling basis, whereby a minimum number of assets are valued each year so as to give a sample of the accuracy of the total programme and after several years all assets will have been valued.
Declaring insured values
- All material and labour required for the reinstatement of the insured property. For owners of real property, it is important to ensure that all aspects of the property that could possibly be damaged are included. Hardstand surfaces such as open air bitumen carparks are commonly overlooked and are a good example of why the declaration of insured values needs to capture all aspects of the property that need to be covered.
- For building owners, any contents, plant or equipment that the owner is responsible for insuring should be included in the declaration. Ideally, any independent valuation will include the value of the owner’s contents.
- All professional fees associated with the reinstatement of damaged property, with the exception of professional claim preparation fees. Claim preparation fees should be covered under a separate and sub-limited section of cover.
- All administrative costs associated with the reinstatement process, including any fees for development applications, statutory licences and permits etc.
- Utility services charges associated with the reinstatement.
- Demolition and removal of debris. It is important to check whether the individual insurer includes demolition and removal of debris costs as part of the insured values; some do but most do not. For those that do not, the costs must still be reviewed to ensure an adequate sub-limit is set but the figure does not need to be included in the insured values for reinstatement.
Ultimately, any property which the policyholder owns or is legally responsible to reinstate and insure, must be included in the declared insured values. The safest way to ensure that all relevant property and all costs associated with the reinstatement of same are included in the declarations to insurers is to obtain an independent valuation, particularly where the valuer has undertaken an onsite inspection of the assets being insured and reviewed relevant leases and contractual requirements. We traverse the benefits of using third party experts in this article.
Extra cost of reinstatement
It is common for reinstatement costs to increase because of having to comply with modern legislative requirements, such as the National Construction Code, that didn’t apply when the property was originally built. Common examples in the current market are requirements in respect of asbestos and flammable aluminium composite panelling. It is possible to insure these increased costs under an Extra Cost of Reinstatement extension. Under ISR policies there is typically some level of sub-limited cover included for Extra Cost of Reinstatement. Under Business Package policies it can be common for the Extra Cost of Reinstatement limit to simply be the difference between the loss and the insured values. However, if it was a total loss there wouldn’t be cover under the Business Package extension. Accordingly, it is important for policyholders to review their policies to determine if an additional allowance has been included for Extra Cost of Reinstatement and that the sub-limit is adequate to meet rising reinstatement costs.
Declaring Loss of Gross Profits / Rental Income
Business Package and ISR Mark IV policies cover financial loss consequent upon damage to the insured property, either as loss of gross profits or rental income. Unlike material damage cover, there is no co-insurance clause for consequential financial loss. If the amount declared is insufficient to meet the loss over the set indemnity period, the policyholder will only be entitled to cover for the amount declared. Conversely, if a policyholder had overdeclared financial loss for the indemnity period, they could theoretically seek to negotiate a premium reduction the following policy period.
When setting insured values for consequential financial loss in the current environment, it is important that increased construction timeframes and supply chain issues have been taken into account when setting the indemnity period. A property that may have taken 12 months to fully demolish and reinstate in 2018 may now take twice as long. Again, independent valuations are the solutions as they will state the periods expected for demolition, development application and reinstatement.
Take aways
Whilst some leniency has been shown by insurers over the past 18 to 24 months as the community readjusted to living with the disruptions of Covid-19 and various global economic and supply chain issues, there is now a real focus on underinsurance and the message to policyholders is clear: if policyholders are not undertaking professional and regular review of their insured replacement values, co-insurance penalties will be applied.
From experience with ISR claims, insurers are now undertaking valuations of assets before even undertaking a site inspection or properly assessing the scale of damage. This demonstrates that insurers are going to be harsher in the enforcement of co-insurance moving forwards.
To avoid being caught out in the event of a major claim we recommend engaging with Bellrock to determine whether insured values and indemnity periods have been adequately set. The biggest take away for property owners is that in order to avoid the guesswork and risk of underinsurance, we recommend obtaining independent valuations annually or on a rolling basis within a valuation programme.
[1] Please refer to the following previous Bellrock Insight Articles for further details:
https://www.bellrock.com.au/jan-2023-market-update-property/
https://www.bellrock.com.au/construction-insolvencies-rising-inflation-and-impacts-on-insurance/
