Value Subtracted

Insurance-to-value (ITV) has resurfaced as a particularly challenging issue for brokers, insurers and building cost technology vendors. Virtually everyone acknowledges underinsurance of residential (and commercial) buildings is real and problematic, but the consensus ends there. Within a wider environment of industry-wide finger-pointing, frustration and acrimony, insurance companies are contemplating the delicate act of bringing premiums in line with updated valuations without raising the ire of consumers.

ITV IN THE FOREGROUND

If the packed audience attending the ITV session at the October 2008 National Insurance Confer- ence of Canada (NICC) is any indication, underinsured properties are a major concern for brokers, insurers and reinsurers. When the session’s moderator, Kevin McNeil, president and CEO of Gore Mutual Insurance Company, asked for a show of hands from attendees if ITV and guaranteed replacement cost (GRC) were a problem, every arm was raised. And thus concluded the only point of agreement between the session participants when it came to discussing the thorny issue of ITV…

Certainly, the numbers from valuation technology providers point to systemic and persistent undervaluing of properties across Canada. MSB (Marshall & Swift/Boeckh), the company with the most widely used building cost software, estimates that about 80% of residential homes in Canada are undervalued by 27% — a figure that hasn’t changed since 1995. When you factor in commercial properties, 60% of which are underinsured by 40%, according to MSB, the result is Cdn$11 billion in lost premiums for the property and casualty insurance industry. That does not necessarily include building contents, which many argue are also woefully undervalued.

“Think about that for a moment: roughly three- quarters of our residential insurance policies are inadequate, and not by a slim margin,” noted Diane Brickner, president and CEO of Alberta-based Peace Hills Insurance Company at the NICC session on Oct. 3 in Gatineau, Quebec. “They cover only two-thirds of the insurable value of peoples’ homes.”

MSB president Peter Wells, also a NICC seminar panelist, observed the Canadian market today is where the United States market was in 1980. “It is a reality in the U. S. that, from 1980 right up until about 2003, 73% per cent of homes were undervalued by 35%. That didn’t change until every property written got a total replacement cost calculation based on a component methodology.”

Many point to the forest fires that spread across the interior of British Columbia in the summer of 2003 as a major ITV wake-up call for Canadian insurers. The fires resulted in more than Cdn$200 million in insured losses, including 240 total losses, mainly in the Kelowna area. According to the Insurance Brokers Association of British Columbia (IBABC), real reconstruction data showed these properties were undervalued by an average of Cdn$100,000 per home.

“Five years after the forest fires, I ask: ‘Where are we? Where do we stand?'” Christian Bieri, managing director of products at Swiss Re Canada, said at the session. “We still have a long way to go. There is still significant underinsurance in the market.”

INCREASING COSTS

ITV has become a hot issue because of the discrepancy between a property’s insured value listed on the policy and the actual reconstruction cost in the event of a partial or total loss. Compounding the problem is guaranteed replacement cost (GRC), which has existed in most Canadian homeowner policies for years. Insurance companies are underwriting and pricing property policies based on what many consider to be inaccurate valuations, while at the same time guaranteeing full replacement costs.

“This is a business model that is quite simply unsustainable,” Brickner said. “It results in a world where there is no accountability, and where there are no real consequences for being underinsured.”

The underinsured part of the equation has been recognized for at least the past five years; the main software providers (MSB, PowerSoft and e2value), brokers and insurers have scrambled to update values to reflect the risks. In particular, several building cost calculator firms have moved to component-based valuation or total component estimating. This method eschews previous factors such as square footage or class-rating of properties; instead, it assigns a value to each component in a home — rooms, flooring, fixtures and so on.

Despite this new method of valuation, however, booming housing markets and surging construction costs — not to mention a startling number of renovation projects — in key regions have surpassed even these attempts to keep pace with property valuations. Although there are signs this boom is slowing down in provinces such as Alberta, British Columbia and Saskatchewan, some say the damage is already done when it comes to valuation accuracy.

“What has happened in the last four or five years is we have had unprecedented but regionalized growth in construction and housing costs,” said Chris Lang, president of PowerSoft. “If insurers are only taking, say, a 5% inflationary increase year by year, then, after about two or three renewals, they will find clients 15-20% underinsured in areas like Alberta and Saskatchewan.”

The actual cost of construction has increased so much and so fast, in terms of both material and labour, the insurance industry has been unable to keep up with it, says Peter Dasilva, vice president of personal lines for ING Canada’s Central and Atlantic regions. “We are in a situation where we are underinsuring a lot of these homes, or insuring them for the wrong value.”

Economic conditions over the past few years have indeed brought more focus to the issue of ITV, says RSA Canada property leader Mike Findley. “Rebuilding costs have increased dramatically, driven by increased demand for materials (therefore higher prices) and labour (much of the labour has been going West to feed the boom in the oil patch).”

Ginny Bannerman, CEO of the Insurance Brokers Association of Alberta, said she has witnessed the trend first-hand in her province. “I have seen professional appraisers go out and estimate the cost to rebuild a house and within a relatively short period of time the estimate is far out of whack,” she noted. “When you look at these increases, it is very hard for brokers to stay on top of them.”

Or valuation technology firms, it seems. MSB’s RCT EvaluRater became a lightning rod for controversy soon after the company announced changes in the spring to its cost calculator. MSB elected to “hard edit” — i. e. automatically include — specific factors that had previously been optional in cost calculations.

These factors include architect’s fees, general contractors’ overhead and profit and debris removal, which, MSB says, are crucial for devising an accurate estimate of true reconstruction costs. The upshot of the changes, however, is that many properties faced valuation spikes of up to 40% virtually overnight, depending on the specific region.

These adjustments have caused a great deal of consternation amongst brokers, who argue that such abrupt moves result in angry consumers and market disruption. Brokers say there are major differences in valuation figures and therefore a credibility problem for technology estimating tools. They note wildly fluctuating estimates could create service issues when it comes to information-gathering and claims handling, not to mention potential errors and omission (E&O) exposures for brokers who fail to provide accurate building or content limits.

In one B. C. case, Strougal v. Coast Capital Insurance Services Ltd. (2008), a customer sued a broker for not obtaining sufficient contents insurance in the homeowner’s policy. The B. C. Supreme Court dismissed the suit, but lawyer Mike Thomas of Harper Grey LLP noted of the decision: “an insurance broker may be responsible for a customer’s loss that is not adequately insured. Howev er, the broker will not be liable if the mistake did not effect the amount of coverage purchased.”

BEST PRACTICES

The ITV issue has hit Western Canadian provinces hard, particularly British Columbia. The IBABC has formed an ITV task force to develop best practice guidelines for residential property valuation.

“So far, the vendors have taken the position that they are correct and they are standing by the numbers and what their products say,” said Ted Lewis, a past president of the IBABC and chair of the ITV task force. “Brokers and consumers, through a lot of the feedback we are getting, feel the calculated numbers are inflated. That creates a huge issue of credibility between the consumer and the insurer.”

Lewis notes the major role of the task force is to clarify with the software providers several of the brokers’ concerns. These would include the amount of data required for a valuation, the ability to implement system-wide upgrades, the ability to apply linear progressions and rating by postal code and consistency of terminology. Lewis also identifies other key issues, including insurance company interpretation of local bylaws vis–vis provincial and national building codes, as well as the standardized use of the Statistics Canada residential construction price index by all insurers.

The IBABC has put together draft guidelines on ITV issues. They address the frequency of evaluation, use of most current software, establishing minimum per-square-foot values for each region, ordering third-party inspections for homes worth more than Cdn$750,000, reviewing change of broker practices and gaining consensus on building codes.

For Lewis, though, it still comes down to a matter of credibility. “The real question is, what is the accuracy of these tools?” he observed. “The average consumer relates to square-footage values. But with the component costing that vendors use, they say: ‘Square footage is not an accurate tool, you can’t use that.'”

Debate about ITV has spread across the country and is fast becoming a matter of national importance for brokers. Insurance Brokers Association of Ontario operations manager Paul Taylor said: “It is very important that any number presented back to a customer is credible. When consumers could be hit with an extra 30-40% on their premiums just for getting accurate valuations on their property, it doesn’t seem like the right way to go. There could be a huge public backlash and it is always, unfortunately, the broker who takes the brunt of that.”

IBABC’s concern about the accuracy of the estimating software is based on a test it conducted in preparation for a symposium it held on the ITV subject last February. In a sample, three different brokers used tools from two different vendors to perform eight evaluations on the same house. Each of the eight evaluations resulted in a different total: the lowest estimate came in at about Cdn$584,000; two were in the high Cdn$600,000s; three provided totals in the Cdn $700,000 range; one stood at Cdn $800,000 and the highest estimate was Cdn$1.3 million. According to the IBABC, any one of these estimates would have met underwriters’ requirements.

Valuation technology providers respond by saying their systems are working, but insurers and brokers are reluctant to take a good look at the long history of underinsured property in Canada. “We have proven over and over again that it works,” said MSB’s Wells. “The question is: Are you (brokers and insurers) really ready to hear the facts?”

Wells again cites the experience in the United States, where insurance companies have been doing total component estimating on every property underwritten. They have also archived the data to account for yearly changes due to renovation projects and other developments. In the United States, company data show the characteristics of a building, not its square footage, play a major role in determining the value of the building, Wells says. A range of other factors include alignment with the proper building code, as well as localized data to reflect materials, overhead and wages. Wells said total component calculations in the United States have resulted in an improvement to date in lost premiums of US$16 billion.

“That is a lot of calculation going on, but that is what we have invested in with our technology, ” Wells noted. “It is a fundamental change and continuous evolution of the business model. What we are suggesting to the marketplace is improving consistently Cdn$11 billion in lost premium in Canada. We want to recover what we think is that exposure.”

Keeping Pace

PowerSoft’s Lang says his company’s Eval- Works engine has steered clear of the major valuation increases experienced by MSB because it has consistently used postal codes to generate local factors for overhead and profit, as well as debris removal, labour and material costs. “We have been able to keep pace with regional growth spurts,” he said. “The year-to-date numbers for construction costs in Saskatchewan for 2008 are about 20%.When we have those increases, you have to keep pace or you will be woefully underinsured, even in one year.”

The reality for insurance companies is that they are in a Catch-22 position when it comes to finding the right balance between premiums and property valuation, Lang adds. “The insurance company people we have talked to have said: ‘Yes, we know it is a problem, but we can’t take more than [a] 5% [premium increase] or we will be pricing ourselves out of the market,'” he says. “So, do they take the reality of the 12- 15% ITV increase, or [do they take] the 5% inflationary increase in premium and have an underinsurance problem down the line?”

Dasilva agrees insurers will confront the issue of balance in the years ahead. “As an industry we have to manage the rate versus the value,” he said. “We are as shocked as the brokers by how much the MSB calculator has moved. But at the same time, we understand why it has. Now we have to figure out together with our broker partners how we move our pricing and valuations together.”

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ITV has become a hot issue because of the discrepancy between a property’s insured value listed on the policy and the actual reconstruction cost in the event of a partial or total loss.

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If insurers only take a 5% increase year-by-year, then, after two or three renewals, clients will be 15-20% underinsured in Alberta and Saskatchewan.

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Total component calculations in the United States have resulted in an improvement to date in lost premiums of US$16 billion.