By: Dr. Deen Letchmiah President of the South African Council for the Quantity Surveying Profession (SACQSP)
THE past year has brought to the fore the importance of being adequately insured in the event of damage or destruction of fixed property. The damage to buildings arising from the civil unrest in July last year (2021) and the subsequent devastation caused by the floods early this year have resulted in building owners having to deal with the consequences of being under-insured.
Understanding how an insurance claim is processed
Although the above events resulted in claims being lodged with the South African Special Risk Insurance Association (SASRIA) for the former and with the insurance companies for the latter, the principle of being adequately insured is the same. In determining the Claim value to be paid, the calculation applied is the Sum Insured (SI) divided by the Value at Risk (VAR) and the quotient then multiplied by the Repair Estimate (RE) i.e. The VAR is the estimated amount required to repair or reinstate the buildings to their original condition at prices applicable as at the date when such damage occurred. The SI refers to the amount stated in the policy schedule together with any specified allowances. The RE is the amount calculated to repair or reinstate the buildings inclusive of all costs, fees, and escalation up to the completion date. The VAR and the RE are usually prepared by a professional quantity surveyor on behalf of the insurance company at the time of the claim.
What happens when you are underinsured?
The recent events have shown that there are many instances of building owners being underinsured and hence having a shortfall to reinstate their buildings. Should the VAR be the same or close to the SI, then the payout will be relative to the RE. However, should the SI be lower than the VAR then the condition of Average will apply which results in a payout shortfall which can sometimes be substantial. Average is applied when the value of the fixed improvements, at the time of damage or destruction, is greater than the insured value. Under such circumstances, the insured is responsible for a proportionate share of the loss.
Insuring for the full reinstatement value
The primary objective of property owners is to ensure their buildings and related infrastructure are adequately insured. Accordingly, the sum insured should be based on a replacement (reinstatement) cost valuation that represents the total cost that will be incurred in the event of damage to the extent requiring complete demolition and reconstruction of the fixed improvements. Reinstatement value is based on the principle that following a loss the amount payable by the insurer shall be the cost of replacing or reinstating the same kind or type of building. The reinstatement value does not relate to market or investment value derived on the basis of potential rental nor any other form of value. Furthermore, it does not include the value of the land. In summary, in deriving an insurance value of fixed improvements the purpose is to provide an estimate of likely costs that may be incurred in total replacement of such fixed improvements arising out of an insurable disaster. The value computed should determine the sum insured that can be claimed against the insurance company. In this regard, the square metre rate of estimating is probably the least reliable and the elemental cost estimating method the most accurate.
Role of the Quantity Surveyor
The professional quantity surveyor is best qualified to advise and prepare a replacement cost valuation. As the expert in quantifying and managing costs on building projects, the quantity surveyor is able to provide a valuation report that clearly shows what the sum insured should be at the policy renewal date.
Understanding the Concept of Escalation in the Sum Insured
The reinstatement value is based on the principle that, following a loss, the amount payable by the insurer shall be the cost of replacing or reinstating the insured property when new. In calculating the reinstatement value, it is assumed that total destruction could occur on the last day of validity of the insurance policy (i.e. on day 365). Accordingly, building cost fluctuations form an integral part of the sum insured.
Prior to computing cost fluctuations during the period of insurance, the valuation must, in the first instance, provide for the total replacement cost applicable at the start of the insurance period in order to accommodate possible loss at that time. The cost comprises the current replacement cost (inclusive of demolition costs and all fees as will be required) at the commencement of the insurance period plus escalation allowances during all stages of the reinstatement.
The first stage (pre-reinstatement stage) relates to the period between the damage occurring and the commencement of the reinstatement work. In this instance, industry-based indices are usually applied. Currently, indices provided in the Building Cost Report published by the Bureau for Economic Research (BER) are accepted as an industry practice for the building sector. The timeline starts from the date of loss up to the decision to proceed with the reinstatement and must account for the insurance assessment period, demolition of existing structures, preparation of new drawings and tender documentation, local authority approval of plans and the evaluation and awarding of the contract. The second stage (reinstatement stage) is the actual reconstruction period during which Contract Price Adjustment Provisions (CPAP) normally apply.
Providing for escalation until the end of the reinstatement period
It is important to consider building cost fluctuations during the insurance period which is normally purchased for a period of one year and renewed annually. If the fixed improvements are valued only at the commencement of the insurance period, by the time the end of that period arrives the fixed improvements would be under-insured due to escalating building costs. It is, therefore, vital that the insured value makes provision for building market escalation during the period of insurance.
