While catastrophes account for the most dramatic examples, the valuation gap goes beyond catastrophes alone.
By Guenter Kryszon, Markel’s Global Executive Underwriting Officer, Property
Over the past several years, the property insurance market has been plagued by challenges in capturing accurate replacement cost valuations. The issue emerged prominently in the wake of the 2017 and 2018 hurricanes, which demonstrated a mismatch between what insureds had reported as their exposure base and the actual economic and insured losses. Undervaluation has been a key contributor to the “model miss” associated with catastrophes, a lack of adequate insurance coverage for insureds, and often economic devastation for areas affected by a catastrophe. Loss creep associated with undervaluation also poses challenges for reinsurance companies in attracting capital and for investor confidence in the underlying exposure base with which they are committing their capital. This includes negative impacts on the insurance-linked securities (ILS) market, such as more trapped capital and dilution of the return for ILS investors.
Undervaluation of a property can also impact partial losses, such as cases where coinsurance clauses are in place or where insured parties utilize the market valuation or purchase price of a building as the basis for the agreed value of a risk. This can result in the insured being exposed to partial losses in cases where repair costs could easily exceed the market value or purchase price of a particular risk.
A review of the factors contributing to undervaluation is timely, especially in view of the growing opportunities that insurtech is providing to capture data elements that can further enhance property valuation moving forward.
The growing impact of catastrophes
The growing divide between economic losses and insured losses has been particularly evident after recent catastrophic events such as hurricanes and earthquakes, where reported losses can continue to increase for years after the event itself. Major recent examples arose from Hurricanes Maria and Irma, as well as earthquakes in New Zealand and Chile. In fact, Munich Re data shows that from 1980 through 2019, 70% of losses from natural catastrophes were uninsured.
Inadequate coverage during a catastrophe can devastate entire communities, with loss of tax revenue from devastated businesses being just one example of the lingering economic impact. A Lloyd’s study from 2018 showed that globally, assets worth about $163 billion are not insured against catastrophes, posing a significant threat to livelihoods and prosperity.
The impact of loss creep on insurers is also significant. A 2019 report from global reinsurance intermediary firm JLT Re showed that claims from Hurricanes Irma, Harvey, and Maria were totaling 17% to 26% more than originally estimated. These substantially increased catastrophic losses are unfortunately being complemented by recent spikes in attritional losses.
From a reinsurance carrier’s perspective, the resulting “valuation gap” affects the accuracy of models used to allocate capital, derive pricing (and associated returns), and ensure that outward reinsurance protection is adequate to minimize volatility. From an insured’s perspective, the “valuation gap” can affect the amount of indemnification the insured can recover. This could potentially expose an insured’s balance sheet to volatility in both the applicability of percentage deductibles, (e.g., where a percentage deductible applies to the values at the time of loss) and the limit (e.g., a name storm or earthquake sublimit) which was purchased based upon the reported valuation.
Additional factors contributing to undervaluation
While catastrophes account for the most dramatic examples, the valuation gap goes beyond catastrophes alone. A 2016 study carried out by the Building Cost Information Service in the UK found that 80% of commercial properties are underinsured. That’s also true for residential properties. According to a 2015 study by the research firm Marshall & Swift/Boeckh, some 60% of homes in the US are undervalued for insurance purposes by an average of 17%.
Many factors are contributing to this chronic lack of appropriate property valuation. Insurance renewals are often resubmitted with the same property values year-over-year. This practice erodes the exposure base used by the reinsurance industry to calibrate the underlying portfolio risk. For the insured, it also distorts the enterprise view of their underlying organizational exposure both at the location level and in areas where accumulation risk could deliver exposures above the limit(s) being purchased.
"Many factors are contributing to this chronic lack of appropriate property valuation."
An insured’s focus is often on building values, which are frequently calculated below the full replacement cost if the building had to be replaced. Some of the increasing trends that are commonly omitted, as the Marshall & Swift/Boeckh study confirms, are changes in building codes, higher labor costs in certain areas (e.g., New York City versus Birmingham, Alabama), and shortages of building materials after a catastrophic event such as a hurricane. All of these omissions can lead to spikes in replacement costs that insureds do not anticipate. For example, after a change in building codes in Charleston, South Carolina, related to seismic retrofits, an insured seeking to replace the portion of a building damaged by a hurricane could be required to bring the entire building up to the current earthquake codes, substantially increasing the replacement costs.
Another area contributing to undervaluation is capturing changes in the replacement value of a building’s contents. Even when contents such as machinery and equipment are updated based on common industry trending data, changes in the technology used by key IT systems and other equipment are often overlooked or not captured in the replacement cost valuation. Many times an insured will determine the replacement cost of equipment based upon a review of an asset inventory register and use trend values to estimate the replacement cost of a given piece of equipment from that register, without reflecting that the original equipment may have used technology that is obsolete today. This can range from advances in the computer equipment used by many types of businesses to shifts in the highly specialized technologies used in many industries.
Business interruption costs are often understated
Businesses also frequently underestimate their business interruption costs. A UK study by the Chartered Institute of Loss Adjusters found that 40% of business interruption policies are underinsured with the average shortfall being 45%. Insureds often overlook such continuing costs as debt payments, insurance, take or pay utility contracts, and taxes. They also sometimes overlook the value of the seasonal peaks that occur in such industries as retail, hospitality, and manufacturing when determining the overall exposure within an insured’s business.
In addition, determining how long it will take a business to resume business as usual is often difficult to quantify, being subject to elongations due to catastrophic conditions, unavailable materials, permissible delays, and other unpredictable factors. Particularly in the wake of a full-scale catastrophe, the loss of societal infrastructure can complicate the Many factors are contributing to this chronic lack of appropriate property valuation.”“ 3October 2020resumption of business, such as after Hurricane Maria, where Puerto Rico’s electric power system was knocked out for an extended period of time. A company’s supply chain may also be impaired, even when the insured’s company itself is relatively unscathed.
The bottom line is that the calculation of business interruption costs is much more multivariable than is often recognized. In summary, if factors such as buildings’ value, the value of their contents, and the full costs of business interruption are not taken into account, the potential exposure that could be realized by a company will tend to be underestimated. This can in turn also impact a reinsurer’s view and capitalization of their underlying exposures, potentially resulting in losses in excess of their risk tolerances which, when taken across the reinsurance industry, could impact the availability of capital for future risks and significantly drive up costs and reduce the availability of capacity for insureds.
Working together to attach undervaluation
Insureds and insurers can and should work together to attack undervaluation on a number of fronts. The right value for a given building can be better established through regular appraisals, which should take place at least every five years.
Trending of values, at a minimum, can provide increased accuracy in keeping the building and contents values up to date. A five-year valuation lookback is readily obtainable using trending data and would help bring a client’s reported values more closely into line, while improving accuracy.
Ideally, this lookback should be supplemented by periodic reviews, which can uncover such issues as added costs of construction due to changes in building codes, changes in the building’s contents, new additions, and other completed building updates. Insurers should also be consulted to provide guidance on the nuances of calculating business interruption costs.
Insurtech enhances opportunities to capture value
Advances in the industry promulgated through insurtech can be an effective tool to more fully capture the underlying data against which the values are being calculated.
The artificial intelligence (AI) being leveraged by insurtechs can provide a more complete picture of the risk, filling in missing data points that insureds may otherwise list as unknowns. AI and sophisticated analysis can be performed on the wealth of data that is available from satellite and drone photography, as well as from building permits, building records, and tax information. All these sources can be used to more precisely determine a building’s height, construction type, square footage, and other factors tied to its valuation, which can more accurately determine its replacement costs.
For example, if a client estimates a building at 100,000 square feet and says it is built with frame construction, the client might value that building at $100 per square foot, or $10 million. However, if the building is actually closer to 150,000 square feet, and is constructed of reinforced concrete, it could be worth $250 per square foot, or $37.5 million, creating a mismatching of risk for the insured and reinsurer.
Beyond using AI to improve accuracy on such factors, data analytics can be used to capture and analyze valuation trends from comparable properties in order to more precisely fine-tune the potential loss exposure from an insured’s property.
In conclusion, addressing undervaluation systematically can yield significant benefits for insureds, reinsurers and society as a whole. It can give insurers, reinsurers, and investors the ability to deploy capital, and give clients more confidence in the insurance being procured to minimize underinsurance.