Viewpoint: Closing the Gap on Insurance to Value

In April 2022, a fire broke out in a Walmart distribution center in Plainfield, Indiana. The fire burned for more than three days, all of the approximately 1,000 employees got out safely and the facility remains closed. Occasionally we’ll see news updates on the investigation and litigation, but behind the headlines lurks an equally important issue that doesn’t get enough attention: the risks of undervaluation.

The property damage claim from the Walmart fire is estimated at about $500 million, though carriers underwrote the location at values ranging from $41 million to $79 million. This is just one of numerous instances where losses were much larger than reported values. This begs the question of how long the industry can sustain this pattern of undervaluation and what can be done to rectify it.

Value adequacy has always been an imperative, albeit at times overlooked, aspect of property underwriting. However, recent events such as the COVID-19 pandemic, outsized inflation, supply chain issues, demand surge, and shortage of skilled laborers have magnified the importance of the issue.

Government lockdowns during the pandemic halted production of critical goods, which later resulted in a shortage when demand for these goods climbed sharply. Reconstruction costs tend to increase 2-4% annually, relatively in line with inflation, but the shortage of both labor and materials have led to increases as large as 8% between April 2020 and April 2021. Additionally, as natural catastrophes continue to increase in both frequency and severity, increased demand for labor and materials after an event creates a phenomenon known as demand surge. The presence of these economic forces means that insureds and brokers are reporting woefully inadequate replacement costs to insurers. Insurance companies charge rates based in part on these reported values and collect far less premium than necessary, which leaves them holding the bag after a large loss.

The most obvious remedy is to write provisions in contracts that protect an insurance company from undervaluation, or even possibly penalize the insured for underreporting. For example:

• One common provision is the margin clause. A margin clause states that the most the insured can collect for a loss at a given location is a specified percentage of the values reported for that location on the insured’s statement of values. These percentages usually range between 105%-125%.
• Arguably even more effective than a margin clause is an occurrence limit of liability endorsement. It states that the most an insured can collect for a commercial property loss at a given location is the amount reported on the SOV.
• A coinsurance clause charges the insured a penalty if the insurance purchased is not at least a specified minimum amount of the value of the risk.
• Finally, an insurer could impose a percentage deductible instead of a flat deductible, especially if it bases that deductible on the value of a location at time of a loss rather than per listed unit of insured.

Vendor tools to assess the accuracy of values are gaining popularity. The most well-known tool is the Marshall & Swift/Boeckh (MSB), which can assess the accuracy of a building’s value based on square footage, year built, number of stories, construction, and occupancy. This tool has earned credibility in the broker and insured community; when an underwriter presents a case of the MSB tool showing certain risks as undervalued it usually gets taken seriously.

Unfortunately, the tool is not without limitations. For one, it can only assess building values, and not contents or business interruption. This can be problematic as business interruption is identified as most crucial to solving the undervaluation issue. Also, the tool won’t work unless all five fields listed above are completed. This is less of a problem for larger insureds, but it can present issues for insureds that don’t have the resources to track down all those attributes. The tool also has limitations when it comes to complex occupancies like manufacturing. Nevertheless, it is widely popular and useful when its limitations are accounted for. There are other vendor tools to help calculate valuations, but assessing their credibility is still in the early stages.

The most effective antidote is education, and management must insist on it. Often an underwriter will learn the vital elements of underwriting such as technical pricing, terms and conditions, deductibles, limits, and cat accumulations; however, it’s imperative to include ITV in this list. Due to volume of accounts and workload, underwriters tend to roll forward exposures when renewal submissions come in without fully understanding the importance of an inadequately valued risk. This is where insurance companies need to make valuation a priority. Carriers can also educate their underwriters in the following ways:

• Flag which occupancies are more likely to be undervalued.
• Offer training on how to fill out BI worksheets.
• Ask Claims to share lessons from losses involving underreported values.
• Stay abreast of changes in laws or ordinances pertaining to standards for rebuilding.

Accurate insurance-to-value is a challenge the property insurance industry will never rid itself of, and it’s never been more important to do so. By implementing even one of the actions outlined above, many insurance companies might find themselves surprised in a positive way the next time a large risk loss like Walmart is reported.