How much to replace it?

In the ongoing series on specialist valuation, we examine the issues that arise when undertaking reinstatement cost assessments for insurance purposes Insurance reinstatement cost assessments, also known as “reinstatement valuations”, are most commonly undertaken for a lender, often alongside a market valuation of the property. They may also be undertaken for a building owner/freeholder, or an insurer or broker, since their in-house expertise varies depending on the size and nature of their business. Insurance reinstatement costs may also be prepared for tenants. All insurance reinstatement costs should give consideration to the precise terms of the insurance policy, title or lease provisions, as well as to the many physical factors outlined below. It is vital that the lender and the insured, who are not necessarily one and the same, have their interests protected. If necessary, separate insurance to cover loss of profits (including rent in the case of an investor) can be arranged. This does not normally form part of the reinstatement cost. There are two principal types of cover: “indemnity” and “reinstatement”. Indemnity This is the original basis of cover, and aims to put the insured back into the same financial position after the loss as they were prior to the loss. The insurance company will deduct an amount for obsolescence and depreciation from the cost of reinstating the property at the time of loss. The insurance liability may therefore not cover the cost of construction of an equivalent new property. Reinstatement Over time, the insurance market has extended the principle of indemnity, and today reinstatement is the usual basis of cover. It allows for a property to be reconstructed in the event of damage or destruction from an insured peril. Reinstatement provides for a property of similar floor area, for similar use, at the place and time of reinstatement. (The particular terms of the insurance policy may provide the right to change the location.) Note that where damage to the insured property also damages neighbouring properties, neighbours’ claims would be against the insured’s public liability cover, rather than their property insurance. It is therefore important that property owners/occupiers also hold public liability insurance. For domestic properties, this would, in fact, usually be covered within buildings/contents insurance. Timing of losses With the effect of inflation, the figure for reinstatement at the date of calculation is unlikely to be sufficient to cover the construction cost following damage or loss at a later date. Consideration also has to be given to the additional time required to obtain planning permission and carry out reconstruction. The insurance industry traditionally took the view that the sum insured should reflect the cost incurred after reconstruction and not at the time of the loss, or at the time the reinstatement assessment was prepared. This caused difficulties in settlement of claims, particularly in times of high inflation. To deal with this, the insurance market introduced “day one reinstatement” policies. Here, the “declared value on day one” is adopted, and an inflation provision is then applied to cover indeterminate increased costs arising during the period of insurance and period required for rebuilding. This will vary depending on the current inflation rates and the size and complexity of the property. The surveyor’s duty is thus to assess the cost of reinstatement at “day one” (which is the first anticipated day of cover under the policy). It is also worth noting that the RICS and the Association of British Insurers suggest that a reinstatement assessment should be carried out every three years, but more frequently in times of extreme recession or high inflation. Property-specific factors, including the carrying out of improvements, could, of course, also warrant a new assessment at any time. Undertaking assessments The following are some of the key issues that must be addressed in the calculation of a reinstatement cost assessment. Measurements For insurance reinstatement purposes, in accordance with the RICS Code of Measuring Practice (5th edition), commercial property is measured on a gross internal area (GIA) basis, and residential property on a gross external area (GEA) basis. If the property is multi-storey and of uniform floor dimensions, the resulting figure is multiplied by the number of floors. GIA measures from the inside of the external walls to include all internal areas. Property type It is important to describe accurately the property type, and also identify different constituent parts, noting that build cost rates can vary considerably between different styles of design, or if there are complex components. Construction “Non-standard” construction features can affect build costs. Examples include solid stone walls, complex drainage systems, specialised foundations and special materials used on the fa!ade. Internally, sprinkler systems, ornate or coved ceilings, grand staircases and the like will need special consideration. Build costs BCIS cost guides provide rates per m2, which may be applied to the GIA or GEA. Spons, Mitchells, and other technical building price books may also be used. The many other elements of reinstatement that the surveyor may have to consider include: Site clearance costs – demolition and debris removal; Environmental hazards – asbestos removal and other site contamination issues; Landfill tax on materials being disposed of; Allowance, via a “location factor”, for awkward access and working conditions – such as vehicle access, noise restrictions, working hours in residential areas, road closures; Shoring and propping of terraced buildings or partially damaged buildings – this can often lead to quite complex engineering solutions; Erection of hoarding in urban locations to protect passers-by; Digging out of old foundations to allow development of a new floor plate, perhaps because of a change to building regulations/planning; Planning costs, building regulations; Architects’ and surveyors’ fees; Compliance with Health & Safety at Work Act, Factories Act etc in ensuring the new building meets current standards; Compliance with the elements of the Disability Discrimination Act 1995 due to come into force in October 2004 (obliging service providers to ensure that disabled people can access their services); and Title and leasehold obligations, and issues under Party Walls Act 1996 Regional factor Location can be an important factor since labour and material costs will differ significantly from region to region. A “regional factor” covers this. Listed buildings and conservation areas These can have a major cost implication for partial or total loss, requiring specialist trades or unusual materials. Separate calculations are ideally provided to the insuring party where the structure is listed or in a conservation area. VAT The VAT position can be complicated, with its treatment depending on whether the insured is VAT registered. Normally, VAT would be excluded. Obsolete buildings Buildings which are either obsolete or in a poor state of repair cannot be insured for the full value of the reinstatement costs. Such condition must be disclosed to the insurer who will then adjust the liability to an agreed figure between the parties. Further information Reinstatement cost assessment is not a valuation in terms of RICS Red Book requirements, although the Red Book in fact does make some reference to cost assessments for residential property. In order to help ensure that surveyors apply a consistent approach to reinstatement cost assessments, RICS have produced the following guides: A guide to carrying out reinstatement cost assessments; Property insurance – some points to consider in relation to the proper cover of risks, 4th edition; Fire damage reinstatement – an information paper; Reinstatement cost assessment and insurance claims, 2nd edition Fiona Gardiner is based in the valuation department of GVA Grimley’s Leeds office, and is a Fellow of the Chartered Institute of Insurers. She formerly worked for Royal Insurance UK, and was a lecturer in Risk Management and Insurance at Napier University, Edinburgh Current issues The increasing cost of insurance There have been considerable increases in the level of premiums over the past 12 to 18 months. This is due in part to the events of 11 September 2001, and also other factors in the insurance market. General insurance companies are required to have considerable reserves held in a liquid form to pay for claims as they arise. The combination of a series of catastrophic losses in the 1980s and 1990s, along with the major recent stock falls (where many insurance companies have traditionally invested funds), have hit reserves badly. As a result, increases in premiums are required to replenish the insurance companies’ reserves. The ability to obtain cover for acts of terrorism is again under review following 11 September 2001. The government compensation fund, Pool Re, was set up in the early 1990s to provide cover in the UK, and its scope is set to widen – involving increased premiums. Flooding has recently seen some insurers refuse to insure properties, including homes, in low lying or susceptible areas.