The commercial insurance landscape in the United States is currently undergoing a dramatic transformation. Insurers are becoming increasingly discerning about the risks they are willing to underwrite, with many retreating from insuring certain industries and states altogether. This shift is primarily driven by a confluence of factors, including rampant inflation, substantial losses on claims for insurers, and an upsurge in the economic impact of natural disasters both domestically and globally. Property insurers, in particular, are intensifying their scrutiny of specific risks. For example, malls housing restaurants with equipment susceptible to causing fires, or auto repair and oil change/tire shops that generate significant pollution and also pose a fire risk, are being examined more meticulously. The surge in natural disasters across the United States, from devastating fires in the west to extensive flooding in the South and Midwest, and an increased frequency of severe hurricanes hitting the US, has further complicated the situation.
Against this backdrop, the underinsurance of commercial properties across the United States has emerged as a grave concern. This issue is being exacerbated by a number of factors, including:
- Clients Not Updating Their Coverage Amounts: A significant number of clients fail to update their coverage amounts to reflect the escalated cost of construction. This oversight can lead to severe underinsurance. For instance, a building valued at a million dollars and insured for $1 million a few years ago would now cost approximately $1.3 million to replace.
- Lack of Understanding of Coinsurance: Many insureds lack a comprehensive understanding of how coinsurance impacts their potential claims payout. The coinsurance clause stipulates that a property owner may receive a reduced claim payout if the commercial property limit is less than the coinsurance requirement, typically 80% or 90%. For instance, an investor who purchases a strip mall that would cost $10,000,000 to rebuild and has a policy with an 80% coinsurance requirement would need to carry at least $8,000,000 in building coverage to avoid a penalty. If they carry less, they would be subject to a penalty on their claim payout.
Let’s consider two examples:
Claim Example 1 (partial loss): Heavy winds knock over a tree that destroys a portion of the building’s entrance and a dining patio. The cost to repair is $200,000.
- 90% (coinsurance) x $10,000,000 (building limit) = $9,000,000 (amount of building insurance limit required to avoid a coinsurance penalty)
- $6,500,000 (actual limit on policy) / $9,000,000 (limit required) = 72.2%
- Claim Payout Calculation: $200,000 (cost to repair roof) x 90% (coinsurance penalty) = $144,000 (claim payout before deductible)
- The insured has to pay approximately $56,000 of the $200,000 total cost to rebuild
Claim Example 2 (total loss): The building suffers catastrophic damage in a fire and must be completely rebuilt. The estimated 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)
- $6,000,000 (actual limit on policy) / $8,000,000 (limit required) = 75%
- Claim Payout Calculation: $6,000,000 (total building limit on policy) x 75% (coinsurance penalty) = $4,500,000 (claim payout before deductible)
- The insured has to pay approximately $5,500,000 to rebuild the property to its pre-accident state
Escalated Construction Costs: The cost of construction has soared significantly in recent years. For instance, the 10,000-unit housing development at Suffolk Downs is currently on hold indefinitely. Three years after winning city approvals, the development was supposed to be well underway. However, amid soaring interest rates and materials costs, securing enough funding has become a formidable challenge. The holdup is a reality plaguing housing developers across Greater Boston over the last two years. Demand in our housing-starved region is sky high, but amid soaring interest rates and materials costs, securing enough funding is a formidable challenge.
Lack of Reinsurance Markets Due to High Inflation: Reinsurance companies, which offer insurance to insurance companies, are grappling with significant losses. This financial pressure has made insurers more cautious about the risks and property coverage they underwrite. Consequently, some insurers are retreating from the commercial property insurance market, reducing competition and tightening their terms and conditions.
Increased Risk from Certain Business Types: Certain types of businesses, such as malls that contain restaurants with equipment prone to causing fires, or auto repair and oil change/tire shops that generate a lot of pollution and are also a fire risk, are being scrutinized more closely by insurers. These businesses represent a higher risk, which can lead to higher premiums and potentially contribute to underinsurance.
Inadequate property insurance limits can have catastrophic consequences. For instance, in the case of the total loss above, an investor could be nearly $5,500,000 short of what it will take to rebuild the property back to its current size and amenities.
To avoid these issues, it’s crucial for businesses to accurately calculate their Insurance-to-Value (ITV), consider the impact of supply chain disruptions, and understand the pressures on reinsurance companies. When purchasing or reviewing commercial property insurance, it’s important to understand the limits included in the policy, what is and is not covered, the coinsurance requirement, and how these factors affect pricing and claim settlements. By staying informed and working closely with insurance professionals, businesses can navigate these challenges and ensure they have the right coverage for their evolving needs. This is especially important in light of the fact that it’s estimated that 75% of U.S. commercial properties are underinsured by nearly 50%. Rising construction costs have led to challenges for property owners, agents, and carriers, with many real estate portfolios failing to keep up with these increases. Misunderstandings about insurance-to-value, ineffective valuation tools, and underestimating reconstruction costs can lead to inaccurate property valuations. As such, understanding commercial property insurance and the impact of coinsurance is vital for businesses across America.
