When buying commercial property, it’s critical that buyers understand the implications of the policy’s property insurance limits. A policy’s property limits affect both commercial property insurance costs, and what is (and is not) covered. In insurance speak, the insurance limit on the policy in relation to what the insurance company requires on the policy is called Insurance-to-Value or (ITV). Insurance valuations that don’t meet the insurance carrier’s requirements can result in significant and unexpected pain when a claim is filed. More on that later in the article.
This has become a major challenge for property owners, agents, and carriers alike as construction costs have skyrocketed. The problem is exacerbated by the dramatic swing in both construction costs and market values that occurred over the last 10-15 years as the U.S. economy crashed during the financial crisis and then accelerated at an unprecedented level for over a decade. Many real estate portfolios have not increased their insurance valuations fast enough to keep up with the rapid increase in costs.
Commercial property owners can end up with inaccurate property valuations for reasons such as:
- A misunderstanding of what insurance-to-value means. (hint: it has nothing to do with market value)
- Ineffective property valuation tools used by the agent, carrier, or real estate investor.
- Annual property valuation increases not keeping up with construction costs.
- Underestimating reconstruction costs in an effort to reduce insurance premiums.
It is estimated that three-quarters of commercial properties in the United States are underinsured by nearly 50%.
Commercial Property Coverage Requirements Explained
To understand how commercial property insurance works, it is critical to understand that insurance carriers require that the property insurance limit on the policy be an accurate reflection of the true cost to reconstruct the building in the event of a total loss. The clause in the commercial property insurance policy that makes this requirement (and states the consequences of it not being met) is called, “coinsurance”. Nearly all business insurance policies include this clause, and it’s something all real estate investors should be aware of.
Coinsurance
Coinsurance on a commercial property insurance policy is completely different from coinsurance on a health insurance policy. The coinsurance clause states that a property owner is subject to a reduced claim payout if the commercial property limit is less than the coinsurance requirement. A typical coinsurance requirement is 80% or 90%. So what does this mean in real-world terms?
Examples
Let’s say a real estate investor purchases a strip mall that would cost $10,000,000 to rebuild, and his policy has a typical coinsurance requirement of 80%. To avoid a coinsurance penalty, the investor would have to carry at least $8,000,000 in building coverage (80% of $10,000,000). If he carries less than $8,000,000, he would be subject to a penalty on his claim payout, even if the claim is for damage to only a portion of the building. The simple math to calculate the coinsurance penalty is the amount of insurance carried divided by the amount of insurance required times the cost of the damage. A few examples for our real estate investor above to demonstrate how this works:
For purposes of this example, we will assume the following:
- True Cost to Rebuild: $10,000,000 (This is called Replacement Cost in insurance. It is the true reconstruction cost of a building. It has nothing to do with market value).
- Building Limit on Policy: $7,000,000
- Coinsurance requirement: 80%
Claim Example 1 (partial loss):
Heavy winds destroy a portion of the building’s roof. The cost to repair is $200,000.
80% (coinsurance) x $10,000,000 (building limit) = $8,000,000 (amount of building insurance limit required to avoid a coinsurance penalty)
$7,000,000 (actual limit on policy) / $8,000,000 (limit required) = 87.5%
Claim Payout Calculation: $200,000 (cost to repair roof) x 87.5% (coinsurance penalty) = $175,000 (claim payout before deductible)
Claim Example 2 (total loss):
The building suffers catastrophic damage in a tornado and must be completely rebuilt. Cost to rebuild is $10,000,000
80% (coinsurance) x $10,000,000 (building limit) = $8,000,000 (amount of building insurance limit required to avoid a coinsurance penalty)
$7,000,000 (actual limit on policy) / $8,000,000 (limit required) = 87.5%
Claim Payout Calculation: $7,000,000 (total building limit on policy) x 87.5% (coinsurance penalty) = $6,125,000 (claim payout before deductible)
As we can see, the consequences of inadequate property insurance limits can be catastrophic. In the case of the total loss, this investor is nearly $4,000,000 short of what it will take to rebuild. In the case of a partial loss, he has to come out of pocket $25,000 (before his deductible is applied) to repair the roof. Note that coinsurance, as it is used on commercial property insurance policies that include blanket coverage, is slightly different than for policies without blanket coverage. Coinsurance can be used as a valuable, insurance cost-saving tool on large, geographically dispersed real estate portfolios that have a very low risk of a significant number of properties being damaged in a single event. For more on how to blanket insurance can be used to provide great coverage and reduce cost, see our article - Blanket Insurance for Commercial Properties.
How do you avoid falling victim to a coinsurance penalty? Having accurate insurance-to-value, essentially ensuring your buildings are insured at a limit that is in line with the true reconstruction cost, is what is needed.
We work with real estate investors every day, and one of the most common misconceptions is that the building limits on their property insurance policy should align with the market value. Only certain, very specialized insurance policies insure buildings at market value, and in most cases at significantly higher rates. Let’s quickly define a few different ways that commercial property can be valued:
- Replacement value—This is an estimate of the cost to rebuild the property. This value fluctuates in line with construction costs including labor, materials, etc…
- Market value—An estimate of what a property would sell for in the current market.
- Assessed value—An estimate normally created by the governing body where a property is located (county, municipality, etc…) This is generally the value used when calculating property taxes.
As stated above, the relevant value in the vast majority of insurance situations is Replacement Value, also known as Replacement Cost. When purchasing or reviewing commercial property insurance, it’s important to review your limits with this perspective in mind.
Property insurance limits are a key factor in determining the cost of commercial property insurance. When buying commercial property and reviewing insurance options, it’s important to be mindful of the different building insurance limits that may be presented. A good advisor will walk their client through the limits included in the policy, what is and is not covered, the coinsurance requirement, have an open conversation about whether or not the limits are sufficient and how they affect pricing and claim settlements.
Camargo Insurance has enjoyed working with real estate investors across the U.S. for over 50 years. Call us today or send us an email to speak with an advisor experienced in insuring commercial real estate.