Environmental and economic factors have driven surges in both commercial property losses and insurance premiums. How can companies ensure they are properly valuing their property risk and obtaining adequate insurance coverage?
Over the past two years, commercial property insurers have experienced unpredictably high loss costs. These losses have been attributed to a number of factors, including: more frequent catastrophic weather events, a broken supply chain impacting the cost of construction materials like lumber and steel, labor shortages in the construction and transportation sectors, and high inflation. Another key problem—and one where risk professionals play a direct part—is the habitual undervaluation of the costs of replacing a damaged building and equipment.
To compensate, insurers have passed these costs on to organizations in the form of higher premiums. Commercial property insurance rates have gone up in each of the past 18 quarters, with rates in Q3 2021 rising between 8% and 12% on a year-over-year basis and varying notably from insured to insured. “It’s a tale of two cities,” said Rick Miller, U.S. property leader in Aon’s commercial risk solutions practice. “The rate pressures are generally modest for better-performing accounts but are well north of that for insureds that continue to report losses.”
While ferocious weather events are the primary cause of damage and destruction of buildings and equipment, the cost of repairing and replacing these assets has soared because of the COVID-fueled supply chain crisis and inflated prices for construction materials and labor. Consequently, the stated asset replacement costs in many insureds’ property insurance policies may be less than the actual expense, resulting in inadequate coverage. This is particularly common among insureds with single-site commercial buildings.
“The industry has seen situations where the asset replacement costs reported by a smaller policyholder with a single-site risk are undervalued by 40%, 50% or more, meaning they pick up substantial uninsured costs in the aftermath of a major loss event,” said Chris Schoeneborn, area senior vice president at Arthur J. Gallagher.
Although increases in commercial property rates are expected to moderate in 2022, current premium levels will remain in place through the year and possibly beyond, according to several insurers and brokers. The industry’s aggregate property loss costs have exceeded accumulated premium volume over the past five years. Further, as insurers invest income primarily in low-yield fixed income bonds and funds, investment income is relatively low due to the protracted low interest rate environment. Overall, property underwriting will likely be more conservative for the foreseeable future.
“Outsized forces like more frequent catastrophic weather events, high inflation, rising costs for construction materials and a shortage in labor are making what has always been a difficult market more problematic,” Miller said. “We are all in an extraordinary situation.”
Extreme Weather Events
For the fourth time in the past five years, insured losses caused by extreme weather events worldwide exceeded $100 billion, with 10 events costing more than $1.5 billion each.
At the COP26 climate change conference in October 2021, the United Nations World Meteorological Organization issued a report finding greenhouse gas concentrations and associated accumulated heat had reached a new record, “propelling the planet into uncharted territory, with far-reaching implications.”
Such implications were made tangible two months later, when a series of 34 tornadoes devastated parts of several central and southern U.S. states, causing an estimated $18 billion in total damages and killing 90 people. The location and time of year were particularly of note, as the December tornadoes struck well after the traditional May through July “tornado season.”
Catastrophic weather events have been striking with increasing intensity and decreasing predictability. The costliest weather event of 2021, Hurricane Ida made landfall in Louisiana and traversed up the East Coast, causing flash floods in New York and New Jersey in early September. Both states had experienced two other tropical storms in the previous three weeks, leaving the soil saturated and drainage systems overwhelmed.
In late-February 2021, a devastating winter storm began in the Pacific Northwest and migrated to southern states, bringing bitterly cold temperatures, tornadoes, snow and ice storms. In Texas, the record cold wave resulted in the nation’s largest power outage in almost 20 years, leaving more than 4.5 million people without electricity for days in freezing temperatures. Claims from the storm are expected to cost insurers at least $9 billion in damages in Texas and $18 billion across the region.
On the last day of 2021, another natural disaster led news cycles as an extremely rare and ferocious grass fire tore through Boulder County, Colorado, driven by winds up to 110 miles per hour. The region was particularly vulnerable after being left “bone dry” from extreme drought conditions, Reuters reported. In a matter of hours, the fire destroyed more than 500 homes and several commercial structures, including a shopping center and hotel.
The United States was hardly alone—regions around the world suffered unusual and devastating weather events in 2021, including:
- In Zhengzhou, China, in July, a month’s worth of rain fell in 72 hours, flooding submerged trains and turning roads into rivers.
- The same month, a heat wave in British Columbia, Canada, pushed temperatures to 121 degrees Fahrenheit, causing hundreds of wildfires across the province, including a blaze that destroyed much of the village of Lytton.
- In Germany, Belgium, Romania, Italy and Austria, severe flooding caused the deaths of more than 250 people and approximately $11.8 billion in total damage costs.
- A historic three-year drought in South America reduced river levels in Brazil, Argentina and Paraguay to their lowest point in more than seven decades, greatly affecting river transport and each nation’s economy.
Outsized Economic Disruption
The year was also marked by a unique confluence of economic factors, including a supply chain crisis; the highest U.S. inflation rate in 40 years; and the so-called Great Resignation, in which an uncommonly high number of employees have quit their jobs.
Global supply chain upheaval was clearly illustrated by queues of container ships idling off the coastlines near ports in Los Angeles and Long Beach through December. Little reprieve for these delays is in sight. Slowed supply deliveries contributed to higher costs for construction materials like lumber, steel and gypsum, a substance in drywall.
In May 2021, lumber costs reached a record $1,700 per board foot, adding more than $35,000 to the cost of building a new multifamily home. In July, rolled steel prices increased 215% year-over-year, and gypsum costs were up almost 16%. Prices of all three critical construction materials fluctuated throughout the year.
Meanwhile, building contractors struggled with a record shortage in the availability of construction workers and truck drivers to transport construction materials, electrical and plumbing supplies, machinery and equipment, and other goods. In October 2021, the demand for truck drivers outstripped supply by 80,000, according to the American Trucking Association. The number of construction workers fell by 115,000 between February and November 2021, the Bureau of Labor Statistics reported, projecting that an additional 740,000 construction workers will be needed in the next three years to keep up with contractor demand.
High inflation further affected the cost of construction materials and labor while also weakening insurer underwriting performance and loss reserve levels. “No one a year ago would have predicted a 7% inflation rate, which factors into how underwriters will look at risk in 2022,” Miller said.
Undersized Asset Valuations
The steep rise in property loss costs is also colliding with the undervaluation of the cost to replace damaged or destroyed assets. This is particularly worrisome for organizations with a single building, as the insurance limits may be inadequate to absorb the ultimate expense. “Ask an insurer what the biggest problem is in commercial property insurance, and they will point to the chronic under-reporting of asset replacement cost values,” said Gary Marchitello, chairman of Willis Towers Watson’s North American property practice.
This issue has become increasingly critical. “I’ve been in the business for 32 years and for 32 years we’ve been complaining about it, but in the last two years, it has gotten worse,” said Gregg Cunningham, executive vice president at Liberty Mutual. “I’d estimate that 75% of commercial properties are undervalued. There is nothing more important in evaluating risk from the underwriting and pricing side as having the right values.”
The problem with valuations is that they are a “snapshot at a point in time,” said Charles Greer, vice president and large property underwriting leader at QBE North America. “The challenge now is all these unusual weather events occurring at the same time as a supply chain crisis and high inflation. The availability of materials and labor is vacillating up and down, causing demand surges when a catastrophe strikes, which sends prices skyrocketing.”
A “demand surge” in commercial property insurance parlance is the equivalent of what happened when the pandemic struck and caused supermarket shelves to empty of hygiene products. In any region, there is a finite number of contractors available to rebuild damaged structures and return people to work. “Obviously, we all need to do more to enhance the accuracy of valuations to ensure that, when a major loss event occurs, policyholders have adequate insurance limits to cover the costs,” Greer said.
Joffre Mishall, U.S. large property business leader for Zurich North America, said the “dream state” for insurers would be a database where every building is indexed as to when it was built, what materials it was built with, when it was upgraded for building code changes, how well it is protected against different types of weather, and how it is used (for example, as a manufacturing facility or office). “But the most important data is the true value of the asset,” he said.
While professional risk managers understand what “valuation” means in the commercial property insurance context, Mishall said an accountant overseeing insurance acquisition may incorrectly interpret it as book value, an asset that can be written off over several years. “That has nothing to do with insurance,” he said. “‘Value’ in our world means the payments required to replace a damaged building and equipment.”
Accuracy in these values is important so that policyholders buy enough insurance to avoid getting stuck with paying uncovered losses. In the current environment, however, brokers warn that increased values will likely result in higher premiums.
What Can Risk Professionals Do?
To provide accurate valuations more in line with current weather risks and economic factors, annual appraisals of commercial property and equipment replacement costs are a step in the right direction. Unfortunately, few organizations put enough effort into the process. “It’s not uncommon to see insureds update the original appraisal report plus or minus a few percent for factors like inflation, rather than doing a full-blown reappraisal,” Mishall said.
While estimating the replacement cost of damaged or destroyed equipment is difficult, it should be done at least annually. “Otherwise, there is the risk of an extended business interruption,” Miller said. “For example, the appraisal may suggest that replacing a particular machine made overseas might take longer to receive, in which case you can plan accordingly for that possibility.”
Marchitello said that Willis Towers Watson is requiring larger clients to provide annual property and equipment appraisals. “We’re demanding they get them appraised each year or appraise a sampling of the properties to the extent they are homogenous buildings,” he said. “We feel this is a rational response to an extraordinary situation.”
In this period of high inflation, Greer said the days of sticking to the same values for three or more years may be over. “It is critical for brokers to coach clients that a $100-per-square-foot building valuation from three years ago is out of line with today’s realities, where it could cost 50% more to replace the building,” he said.
In addition, risk managers and brokers can benefit by enhancing the accuracy of their data exchange. “In many cases, the valuations come to us in different formats,” Cunningham said. “We laugh about it internally, joking that the statement of values is like a snowflake—no two are alike.”
Expanded use of data and analytics tools can also help provide a more refined understanding of commercial property risks, which may help close the gap between asset replacement cost valuations and projected losses. Various products combine geospatial imagery, deep-learning algorithms and artificial intelligence to analyze property risks and loss data either for single buildings or across portfolios. The information gathered can allow organizations to improve their property risk management practices and obtain better insurance coverage.
As the global climate changes and a range of economic challenges impact the market, it is more important than ever for organizations to gain a better understanding of their commercial property risks and valuations to ensure they have adequate insurance protection in place at the appropriate price. Russ Banham is a veteran business journalist and author based in Los Angeles.