Insuring the future

The UK commercial property industry may not appear to be at risk from aftershock from the recent Japan earthquake, but with expected increased insurance premiums on a global scale the tremors could shake property owners sooner than they think.

Add to this the rise in the number of major flooding and fire incidents in Britain and there is a very real reason for ensuring that property owners not only have a sound insurance strategy, but that their premiums are based on accurate reinstatement costs.

In the first quarter of this year the big reinsurers were all reporting heavy losses and primarily putting it down to natural disasters, meaning underwriters are likely to be looking for the chance to increase premiums to cover their losses. One vital element of a sound insurance strategy is an accurate reinstatement cost assessment (RCA) and getting this right is key to minimising risk from disaster.

Avoid disaster
An inaccurate RCA is going to have serious financial implications for a property owner, whether over or under estimated.

Insurance premiums are partly dictated by the estimated cost of total reinstatement of a property. If the cost of rebuild is overestimated that will be reflected in a premium that is higher than is necessary, meaning wasted expense for building owners. With premiums on the up in general, this is going to hit budgets even harder than first previously thought.

On the flip side, an assessment that under values the costs will result in lower premiums but, should disaster strike, could mean that property owners find themselves with a shortfall between the level of insurance cover and the actual cost of reinstatement. The worst case scenario for any property investor is only discovering that they are under insured once their investment has been destroyed.  Even when the cost of damage is well within the sum insured, the underwriters may still apply ‘average’ and make a pro-rata reduction in any pay out resulting from the policy.

It is estimated that the total global cost of natural disasters in 2010 was a staggering $218bn (£131bn), of which a mere 20 percent were insured losses. Similarly, the Environment Agency reports that in the UK, only 75 percent of the damage caused was actually covered by insurance.

Ensuring accuracy
Most building insurance policies are based on ‘Day One’ reinstatement costs, where a declared value is provided by the building owner. This is the estimated cost to rebuild the premises on the first day of the period of insurance and to include associated costs such as demolition, site clearance and professional fees. Insurers will use the declared value to calculate the ‘sum insured’ usually by applying a percentage uplift to deal with inflation during the policy period, and to provide a degree of contingency.

As construction prices have fallen over the past few years the risk of the sum insured being insufficient has also fallen.  However, the RICS Building Cost Information Service predicts that construction costs will rise by 2.8 percent in the year to forth Quarter 2011, and by 3.1 percent over the following year, driven by increases in input costs. With the prospect of construction cost inflation returning over the next few years, it is as important as ever to make sure that the declared value is completely accurate.

Accuracy depends on a broad understanding of construction and development issues, landlord and tenant relationships and insurance policies. It is widely known that the location of a building will affect the rebuild costs, but equally important to take account of building specific issues, such as river frontage or railway lines in close proximity.

While most policies are based on indemnity by reinstatement – that is to say new for old – it is also necessary to consider the effect of building regulations and other statutory provisions such as DDA that might mean that the notional replacement building on which the declared value is based has to be different from the actual building.

Tenant’s fit out works may be covered by their own business insurance policies, and can be excluded from main policies to avoid duplication of cover, but again care must be taken to make sure that elements of the building are not excluded from cover.

Reinstatement costs are often based on published average rebuilding costs, but this too can be a dangerous approach, as actual construction costs will vary considerably from building to building, depending on the standard of construction and the quality of finishes. It is easy to see that an office within a listed building with ornate internal and external finishes may well be considerably more expensive to replace than a similar sized modern counterpart.

In April 2011 the RICS published a revised guidance note: ‘Reinstatement cost assessments of buildings’ which is intended to improve standards of production of RCAs, and to bring consistency and uniformity to the process. It includes guidance on the use of an elemental approach to calculating rebuilding costs, a technique that produces a figure tailored to the building in question, and therefore improving accuracy.

Taking all of this in to consideration, for commercial property owners and estate managers, it is advisable to ensure that your RCA consultant has the requisite expertise to calculate the declared value figure, on which the insurance of the property and protection of the asset is based.

A thorough RCA should be carried out on a portfolio once every three years, with annual updates prior to policy renewal. The reinstatement costs should also be reviewed when buildings are altered. This ensures that the increased size resulting from a building extension, or an increased specification, for instance the installation of air conditioning into a building, are taken into account.

With premiums predicted to rise at the next renewal date, now is the perfect time to make sure your reinstatement strategy is in full working order and your financial risks are minimised.