How inflation affects insurance replacement cost

Oct 15 2018

Building insurance cover is typically issued based on its replacement value. The replacement value of your property at the time of policy inception will unquestionably be affected by inflation during the period of cover.

Inflation

The costs of building materials, building services and other professional fees (such as architects and engineers) will increase over time. The replacement value on day 1 of your insurance will not necessarily be the same as that on day 364. It is advisable to make allowances for the effects that inflation will have on the cost of replacing the property. This is done by way of the Escalation and Inflation clauses in your policy.

Moreover, inflation will continue to reduce replacement values after the date of loss. This could take some time – as much as two years or even longer – until the property is finally reinstated.

Escalation

The valuer will account for escalations in their determination of replacement costs; these amounts need to be properly structured in the policy.

In the sectional title environment particularly – where we may be referencing cover valued at hundreds of millions of Rands for a single policy – these escalation figures are important to understand.

By definition, cost escalation includes the changes in the cost of specific goods or services in a given economy over a period. Escalation is usually calculated by examining the changes in price index measures for a product or service.

There are two types of escalation figures:

  1. Escalation during the period of insurance.

Short-term insurance policies – which includes common policies associated with ‘buildings cover’ – are normally 12-month policies, even if the policy automatically renews. Thus, the inflation rate needs to be accounted for during this period.

For example, let’s assume Building Cost Inflation is projected at 12% for the year, i.e. 1% per month. Seven months into the policy year catastrophe strikes and the buildings are completely destroyed.  If correctly structured, one expects the insurer to compensate the sum insured + 7% (7 months x 1%) for this portion of escalation.

  1. Escalation during the period of reconstruction and redesign

In the ensuing months following the event, a number of experts will assess the situation and much negotiation will take place. The remains of the building will need to be demolished and the rubble removed. The buildings may need be redesigned by architects, costings done and plans passed before any reconstruction can begin which can take 6 months or even longer. In that time, inflation continues to erode the sums accounted for so far. This is deemed the period of redesign.

Next the contractors move onto site and reconstruction commences; this period until the construction is completed is called the period of reconstruction.

For ease of calculation and reference, we string these two periods together as the period of reconstruction and redesign.

In most policy quotations and schedules, escalation during the period of insurance is often referred to as ‘escalation’ and escalation during the period of reconstruction and redesign is often referred to as ‘inflation’. This is not usually properly explained and can lead to many incorrect assumptions and under-valuing for these periods.

For this reason, it is important that the valuer or quantity surveyor properly ascertain these figures. The location, the nature and type of the buildings along with a few other factors will be considered.

Ground Zero in New York (a.k.a. 9-11) is a great example. This structure took 17 years – from the event in 2001 until 2018 – to finally complete. This illustrates that the process to reinstate a completely destroyed building takes far longer than one would think, much more than simply adding 10% for inflation.

Replacement value and replacement cost

It’s important to understand exactly what replacement value is: It is the current cost to replace a building, i.e. to reinstate a property to its original state if completely destroyed. This excludes the value of the vacant land itself and it is usually determined by adding the estimated cost to replace the buildings (contract price), professional fees, demolition costs plus VAT.

When considering insurance replacement value, one need to consider replacement cost: the cost to construct a structure with the same utility as a comparable structure using today’s materials and standards. In the case of a heritage building, you consider the reproduction cost: the cost to construct an exact duplicate of the subject structure at today’s costs. For simplicity, we will assume a pure replacement value.

For example – the policy should reflect the following (at policy inception date):

R100 million – Sum insured (equal to replacement value)

R12 million – Escalation (during the period of insurance)

R12 million – Escalation (during period of reconstruction and redesign)

There are no automatic default escalation or inflation figures. As mentioned, these three figures should be properly determined by the professional valuer or Quantity Surveyor (QS).

In a previous blog – Determining replacement values: The trustees’ responsibility – we set out how to deal with the figures.

Escalation rates

When a quantity surveyor or valuer sets out their construction costs, the escalation rates (pre-construction, construction, post-construction) are sometimes included in the overall replacement value – other times, these numbers are only partially included. This can cause some confusion; an inexperienced portfolio manager or insurance broker will use this figure as a base and then add escalation figures on top of that. The correct way is to first take out the applicable escalations, reset the replacement cost and then add the escalation figures as indicated above. Basically, you take the valuer’s figures and putting it in an insurance policy format so that premiums for escalations are not double charged. In such cases, we normally ask the valuer to set out a summary in ‘insurance policy format’ so that the valuer confirms the correct figures.

On a building of R500million – for example – escalations could comprise from R50million up to R100million, depending of the nature of the building. It is quite wasteful to pay full premium on these amounts where most insurers charge 50% and 25% on the escalation figures respectively, some charging even less – if any premium at all.

Trustees, managing agents and portfolio managers need to ensure that they understand the valuation schedule received. They should also receive proper advice from their insurance intermediary regarding sums insured and the structuring of their escalation figures in their policies.

 

Author: Mike Addison

Contact Addsure – The Leaders in Sectional Title Insurance – to get fit and proper advice from advisors who understand Sectional Title. Contact us in Johannesburg (011) 704-3858; Durban (031) 459-1795; Cape Town (021) 551-5069

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