Fire, theft, or flood that result in damage to assets can compromise key business processes, impacting the ability of a business to continue operating efficiently. This is referred to as consequential business interruption losses, directly resulting from the asset damage incurred.
If the insurance declared values for the material damage and business interruption are incorrectly stated by the insured on the policy, the resulting settlement by the insurer/s can be significantly less than expected or required for the business to recover to continue as a going concern.
The complexity of the insured value of loss is aggravated where:
- The original plant and machinery to be replaced must be imported or is no longer in production. As insurers settle on “new replacement value” and not “book or acquisition value”, there will be additional costs (civils, electrical, forex, transport) for workarounds if a different specification plant is the replacement. These factors contribute to what the Estimated New Replacement Value (ENVR) should be.
- It costs significantly more to rebuild a destroyed building, to ensure compliance with the latest building regulations.
“It is imperative that a current and accurate fixed asset register is maintained. Professional valuators can then review and update the asset register annually, to ensure the declared values are consistent with the anticipated insured periods (a loss could be 11 months after declaration),” says Craig Kent, the head of risk consulting at Aon South Africa.
“The register will be able to provide for the accuracy of an insured’s annual property declarations and for the correct insured values to be attached to each asset, in accordance with the required insurance indemnity, normally the ENVR.”
Why correct declared values are important
Declared insured values refer to the specific amounts of coverage that policyholders are required to declare or disclose to their insurance company annually or periodically. These values are based on the client’s view of their property and operational risk and may include various depreciation and escalation factors, such as variation of construction costs and the Consumer Price Index (CPI). They form the basis of the underwriting review of the insured’s risk and how this could be covered in terms of direct insurance and re-insurance cover.
The correct declared insured values ultimately determine the amount of coverage that the insurance policy will provide come claims time. If the declared insured values are too low, the policy may not provide adequate coverage to protect the business fully in the event of a loss, resulting in underinsurance, where the insured technically co-insures for the shortfall.
If the declared insured values are overstated, the insurer will not pay out the higher value, because it will settle only to the replacement value or loss limit. Overstated values result in higher premiums for coverage that is not needed in addition to higher loss limits than needed, which could influence the market’s risk appetite and rates.
“Having accurate declared insured values is fundamental to the insurer being able to properly underwrite the policy, assess the risk of insuring the business, determining the appropriate premium to charge and assessing the claims settlement amount in the event of a partial or total loss,” Kent says.
Calculating declared values correctly
Declared values are based on a complex calculation that works from a basis of the original cost, but also needs to take into consideration factors such as CPI, the Building Cost Index, the Producer Price Index, Personal Consumption Expenditures, and gross domestic product, Kent says.
“When it comes to insuring a business, the process can be especially complex, so it is highly recommended to make use of a professional registered valuator who will consider all aspects of the client’s property and operations, including fixed and movable assets, to provide a professional overview of the calculatable risk exposures the client may be faced with when it comes to reinstating the business to the same condition/state it was in before an incident,” Kent says.
The basis of the original cost, on which all calculations are based, can be calculated using two methods (note: the option must be aligned to the indemnity requested by the risk carrier):
- Fair Market Value (FMV) is the price that a property or asset would sell for on the open market, assuming that both buyer and seller are knowledgeable about the asset, are behaving in their own best interests, are free of undue pressure, and are given a reasonable time for completing the transaction.
- ENRV is the replacement cost of an existing asset with a similar asset at today’s market prices. The asset in question can be a real estate property, investment security, or account receivable. From a property point of view, the ENRV considers the catastrophic loss of a facility and includes:
- Clearing and removal of rubble and waste;
- Architectural design;
- Professional fees, including fire engineering and structural engineering;
- Local authority submission and approval;
- Preparation of site for reconstruction;
- Construction; and
- Approval of construction.
Case study: FMR vs ENVR
The following case study illustrates the difference between these two calculation methods:
Company A purchased an office facility in Gauteng and paid a total of R78 340 697 and all legal and incidental costs. The building was purchased for the purpose of using the first two floors as a head office and sub-letting the remainder of the office space, with the value accepted as a FMV, meaning it was considered as a reasonable purchase price.
When considering its insurance options, Company A decided to have a professional valuation completed by a reputable and registered valuator. The ENRV for the building was returned at R316 600 000, illustrating the difference between FMV and ENRV.
“If Company A decided to insure its property using FMV as the basis of calculation, the property would be underinsured by 75%. In such an event, the insurer will assume that you have elected to carry a portion of the risk yourself. As a result, you may find yourself in a situation where you are paid partially for a loss at claims stage due to the average formula being applied. It means that if your property is underinsured by 40%, for example, then you may only be paid out for 60% of your claim, regardless of whether it is a partial or total loss. And while the client would have saved money in terms of premium expenditure, the underinsurance would have a negative impact during the claims process,” Kent says.
If the client had an incident where a claim was lodged for R25 million because of a fire at the premises of Company A, the claims calculation would be:
[R78 340 697 (FMV) ÷ R316 600 000 (ENRV)] x R25m (claim) = R6 186 094 (claim pay-out value)
“As can be seen, the claim pay-out value of R6.1m is not sufficient to cover the loss that the business suffered of R25m and is likely to have dire financial consequences for the business. If the declared insurance business interruption insured values are also incorrect, then the business would have unsustainable business interruption costs, further impacting its ability to fully recover from the loss,” Kent says.
It is imperative for clients to ensure that their declared insurance values are based on factual input that is evaluated regularly to obtain a certified valuation on business assets such as property, plant, equipment, furnishings, finishings, processes, transportation, warehousing, and stock, Kent says.
“Ensuring that the methodology used to calculate declared values is accurate provides the business with the necessary data and insights it needs to make decisions that are better informed on what the business needs to overcome adversity, at the time of claim. This is achieved by completing a comprehensive professional valuation on every building, or at least conducting professional valuations on a rotational basis that ensure the comparative internal calculations are functional and within the scope of expectation,” he says.
