When purchasing or renewing commercial property insurance policies, it is important for businesses to ensure that such coverage includes accurate property valuations. Doing so can make a big difference in providing adequate coverage and preventing coinsurance penalties amid covered property losses. That’s where performing accurate insurance to value (ITV) calculations comes in. Generally speaking, ITV refers to a calculation of the full cost of replacing or restoring insured property.
Companies can end up with incorrect ITV calculations for a variety of reasons – whether it’s due to using inefficient property valuation methods, deliberately underestimating costs in efforts to secure reduced premiums, or being affected by factors beyond their control (eg inflation). Regardless, such inaccuracies are all too common. In fact, an estimated 75% of commercial properties are underinsured by 40% or more, according to industry data.
With these results in mind, it̵
7;s clear that companies need to take commercial real estate valuations seriously. This article provides more information on ITV, outlines factors to consider when determining a property’s value, explains the pitfalls of property undervaluation, and provides best practices for improving property valuation measures.Commercial property coverage ITV explained
An accurate ITV calculation represents as close to an equal relationship as possible between the amount of insurance a business obtains and the estimated value of its commercial property – ensuring adequate protection following property losses.
However, it is important to remember that a property can be assigned several different values, including the following:
- Market price—This value is an estimate of what a property could be sold for in the current property market. The market value of a property is based on elements such as lot size, building condition and location desirability.
- Assessed value—This value is an estimate generated by the municipality where a property is located. Such a value is typically used to determine local property taxes.
- Replacement value—This value is an estimate of the current cost to replace or rebuild a property. The replacement value of a property depends on characteristics such as material and labor costs, architectural services, debris removal needs, and building permit requirements.
In general, insurance experts recommend using the replacement value of a property to perform accurate ITV calculations. Common approaches to accurately estimate this value include obtaining a property appraisal from a third-party firm, utilizing fixed assets that have been adjusted for inflation, or relying on a basic benchmarking tool (eg, dollars per square foot).
Although appraisals often require more time and resources than other property valuation methods, they are largely considered to be the most accurate and accurate.
Factors that affect property value
In addition to using estimates of replacement value within ITV calculations, companies should consider the following factors to determine accurate property valuations:
- Direct and indirect expenses—In addition to direct costs, such as material and labor costs, property appraisals should include indirect costs, such as consulting fees, engineering services, and other expenses not directly associated with remodeling.
- Property age—In the case of older structures, property valuations should include additional construction costs that may arise when upgrading outdated building materials and equipment.
- Building regulations– Older properties may also require certain changes during the remodeling process to comply with modern building codes (eg, plumbing improvements, energy efficiency improvements, sprinkler system changes, and safety improvements). These adjustments can further exacerbate construction costs and drive up property values.
- Property availability—Properties located in steep locations or adjacent to neighboring structures may need support or other safety measures during demolition and reconstruction to ensure accessibility. These measures should also be taken into account in property valuations.
- Unique features— Some custom property elements (e.g. stained glass) may require specialized construction work, increasing remodeling costs. Therefore, it is crucial that these unique characteristics are incorporated into property valuations.
Consequences of undervaluation of real estate
Companies can face a number of consequences if they make incorrect ITV calculations and undervalue their properties. Namely, companies may lack adequate coverage after property losses, forcing them to pay out-of-pocket expenses to be able to rebuild completely. Depending on the severity of property losses and associated rebuilding efforts, paying these costs can lead to major financial setbacks and – in some scenarios – bankruptcy.
In addition, property undervaluation can sometimes result in coinsurance charges. Most commercial property insurance policies include coinsurance clauses, which encourage policyholders to carry reasonable and accurate coverage amounts. Under a co-insurance clause, a policyholder is subject to a penalty – generally a reduced payout – if their coverage limit is not at least equal to a predetermined percentage (usually 80%) of the value of their property.
A co-insurance fee limits the amount that can be recovered after a loss. To calculate the amount recoverable for a policyholder who does not meet their coinsurance clause requirements, the sum insured should be divided by the amount of insurance required and then multiplied by the claim cost. For example, if an insured’s property is valued at $1 million, but their coverage limit is $700,000 and their policy includes an 80% coinsurance clause, they would likely only receive a payout of $43,750 after sustaining $50,000 in property damage from a covered event, depending on when their deductible is applied ((700,000/800,000) x 50,000 = 43,750).
Ways to Improve Commercial Property Coverage Valuations
Here are some additional best practices companies can review to ensure accurate ITV calculations and improve their property valuation efforts:
- Find a serious appraiser. Third-party valuations are considered the gold standard in property valuations by insurers, as they offer assurance that calculations were carried out by experienced and objective professionals. As such, it is important to get a reliable and reputable appraiser. Be sure to find a company that adheres to the Uniform Standards of Professional Appraisal Practice and the Appraisal Institute’s Code of Professional Ethics and Standards of Professional Practice.
- Find additional resources. In addition to obtaining a valuation, there are additional industry resources, reference guides and validated tools available to ensure accurate property valuations. Specifically, the Marshall & Swift Valuation Service Cost Manual is a tool widely accepted by insurance companies. This resource has more than 30,000 component costs across 300 buildings that can be referenced when making valuations.
- Consult other parties. Determining the value of a property should be a team effort. Be sure to compile a variety of property data from multiple qualified parties (eg, accountants, contractors, real estate experts, risk managers, insurance professionals, and CFOs) when making valuation decisions.
- Make updates as needed. The value of a property changes all the time. This means that it is imperative to update property valuations regularly. For example, evaluations should be done at least every three to five years. Please note that property valuations may need to take place even more frequently. The frequency will depend on factors such as changing real estate exposure, changing operations, building upgrades or modifications, implementation of new technology or equipment on site, changing market conditions and real estate construction trends (eg, high labor and material costs). It’s best to work closely with trusted insurance professionals when updating property valuations to maintain ample coverage and prevent coinsurance penalties.
Conclusion
Ultimately, it is clear that accurate property valuations are critical to securing adequate commercial property insurance. By better understanding how to perform proper ITV calculations, companies can remain protected when covered events occur and avoid potential coinsurance penalties. If you want to know more, contact one of our licensed advisors. We are here to help.
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