Measuring Property Coverage Limits

There has always been a lot of confusion in the market as to what dollar limit should be used in property policies, be they residential or commercial. Terms used to define the limit, such as market value, new construction and reconstruction, contribute to the confusion. The correct answer, reconstruction, is quite straightforward. Knowing why reconstruction is used can help to make the concept clear and understandable to everyone in the market.

COMMON MISCONCEPTIONS

Most of us have experienced conversations with others who feel proper coverage should be equal to the market value of the property. After all, if that was the amount paid for the property, shouldn’t that be the amount used to insure it against loss?

Others feel coverage should be equal to the amount quoted by a contractor for new construction of the building. This seems to make sense, especially when it comes from a credible contractor. However, both of these views are wrong.

Market value is a speculative, market-driven number that involves many factors, including land, location, the building and its fixtures, services, neighbourhood, landscaping, access, local supply and demand and many others. Market value is usually much higher than the cost to rebuild, although in some instances it can be lower.

New construction quotes, although they are closer to the true cost of reconstruction than market value, also miss the target in significant ways. Many of the individual costs within new construction quotes are wrong; many more are missed altogether. These quotes can easily deviate from the actual reconstruction cost total by 30% or more. The exact percentage error will vary on a case-by-case basis, but a significant error is fundamentally true in all cases.

When a property loss occurs, the coverage should include the total amount of all of the anticipated costs associated with the reconstruction of that property back to its previous state in a very timely manner. The anticipated costs associated with the reconstruction of the building are as follows:

Costs Associated with Urgency

Property losses are not planned. When they do occur, there is an immediate need to rebuild as soon as physically possible. Apart from the serv- ice imperative of getting families and businesses back into their homes and buildings, other financial drivers contribute to the need for urgency. These drivers include costs associated with temporary relocation, business interruption and temporary operations, among others. Minimizing these costs, which increase over time, means urgency must be applied to all reconstruction efforts. That means the price of services, labour and materials will be higher compared to the costs associated with pre-planned construction projects. Incremental cost (Approx.):5%.

Demolition and Debris Removal

Major losses almost always require the demolition of still-standing structures and the removal of debris. This must be done for safety reasons and to prepare the site for reconstruction activities. Debris includes not just above-ground building debris but also foundation cement and materials. In addition, it includes soil contaminants resulting from the loss event and dangerous materials like asbestos. The incremental costs created by this activity can range from 1% in minor losses up to 150% in extreme cases.

Incremental cost (Approx.):5%.

Architect Fees

In new construction, architectural fees are spread over many similar and identical homes being built in one or more subdivision projects. Commercial contractors also minimize costs over many similar new buildings from site to site. But in reconstruction, no such economy of scale exists. New, one-of-a-kind plans need to be drawn up from scratch as quickly as possible so that planning can begin. A premium is paid for the custom work and for the shortened lead-time.

Residential/Small Commercial Incremental Cost (Approx.): 10% to 25%

Large Commercial Incremental Cost (Approx.):4.5% to 15%

Specialty Structures Incremental Cost (Approx.) 16% to 20%

Materials and Labour

Loss reconstruction projects are forced to pay premiums for all services, materials and labour. All benefits from purchasing in bulk and scheduling activities well in advance are lost. These higher prices could be further inflated if the loss occurred during the wrong season, or if local labour resources and materials are scarce. Incremental costs might vary wildly depending upon exact local circumstances. To grasp the full ramifications of this, just consider a scenario in Whistler, B. C., in which a commercial building suffers a total loss and needs to be reconstructed at this moment in time. Based on the short supply and increased demand for materials and labour in the area because of construction associated with the 2010 Olympic Games, the materials and labour costs would be incredibly higher than under normal circumstances.

Incremental Cost (Approx.): 7.5% to 50%

Worksite Access and Collateral Damage

Under new construction, worksites have a lot of room for work areas and material storage. But at reconstruction sites, there is typically less room because of debris, landscaping, fences and other buildings. This causes more work and material storage to be done further away from the site, thus extending project time and cost. In many cases, physical access requirements result in collateral damage to existing property on and beside the insured’s property. Getting heavy equipment through to tear down dangerous walls and structures serves as a good example of incremental collateral damage expense.

Incremental Cost (Approx.): 1% to 2%

Inflation

If a loss occurs nine months into a policy, inflation might well have increased material and labour costs dramatically since the policy’s inception. And yet the insurer must pay the higher prices to meet the policy’s terms. This type of additional cost is not incurred for new construction because materials and labour costs are usually negotiated ahead of time. Take the cost of structural steel, steel studs and reinforcing bars, for example: for all of these materials, prices increased by well over 40% between 2004-05 due to market shortages. Inflationary and wild price fluctuations cannot be predicted easily and can become extra costs for insurers.

Incremental Cost (Approx.): 0% to 5%

General Contractor Profit and Overhead

These two items are pretty standard in the construction industry, but in reconstruction the percentages are taken against a higher cost. This increased amount covers extra costs incurred during the management of a more complex re-construction project. If the total net increase in cost for reconstruction versus new construction is only 25%, then the approximate incremental cost for profit and overhead would be real. Incremental Cost (Approx.): 5%

SUMMARY

Once all of the factors involved with re-construction versus new construction are understood, it becomes evident that re-construction costs will always be demonstrably and significantly higher. The incremental percentages listed can be argued one way or the other and will vary from reconstruction project to project. But the fact remains that these incremental costs are real and need to be included in property limits to protect the insured and the insurer alike.

The author would like to acknowledge that e2Value, an information service provider to the Canadian property and casualty industry, supplied some of the data used in this article.

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Market value is usually much higher than the cost to rebuild, although in some instances it can be lower.