Building Insurance Valuation Methodology

The aim of this article is to highlight the difference between two major approaches to determining the insurance value for buildings. The reason why it is important to understand the difference is due to the direct consequences it has on the accuracy of the final insurance value that in turn affects and determines the monthly insurance premium you will be paying and the possibility of exposure to average, as applied by insurers in the case of a claim.

We will not be addressing the insurance valuation methodology of movables assets or plant and machinery in this article.

Let us assume you want to insure your residential property, commercial office, retail store, industrial building or even a historical building on an estate. There are two major approaches to determining the insurance value that you should insure it at. The first and the most preferred is a bill of materials and labour approach and the second is the estimated cost approach.

Approach 1 – Bill of materials and labour

This method considers the elements of a building and determines the new replacement cost (or reproduction cost, please see the “replacement cost versus reproduction cost” paragraph below) of each element. For example, during the site survey (/inspection) measurements are taken of the actual windows, door frames, roof trusses and roof cover, soffits, walls, ceilings, sanitary ware, plumbing, drainage, gutters, floor covers, etc. that forms part of the building. These measurements are necessary to determine the cost of each element if the building is to be replaced (or reproduced). Allowance needs to be made for the labour involved in establishing elements such as electricity, fittings, drains, etc. On the one hand there is the cost of the actual building material, but on the other it has to be constructed or installed. A full bill of material specifies every aspect of the property including the number, kg, litre, linear meter, square meter, cubic meter, rolls, and days per specific sub-type of element. For example, under the door frames it can be noted that there are ten (10) Steel jamb 813x115x0.8mm RH door frames in the building, or there are two (2) Win Swartland WC2F L/R windows in the building. The property might need 81.51 m³ of filling with 2.36 m³ 13mm stone for the cavity (15MPa) that is hand mixed as a super allowance. Or under sanitary ware, the building will need to be replaced with two (2) basins on brackets, one (1) basin with pedestal A, (one) 1 basin vanity and cabinet (1200 B), four (4) WC pan and cistern (LL A), one (1) double sink 1800 SS double centre drop in, two (2) sinks 1500 Karran into double end bowl, etc. This is just to illustrate that every detail of the building is taken into account in the case of a bill of materials and labour approach.

From a methodology process point of view, the valuation starts with the client giving an instruction to inspect the property (/building) and conduct a site survey. When the surveyor arrives at the property, he or she starts the site survey process and measures the building(s) in the detail described above. An average residential property takes approximately four (4) hours to survey. Once this is completed, the surveyor performs market research on the material costs and labour costs for your specific area and apply it to the bill of materials and labour. After this, the surveyor must still add two categories of allowances, namely fees and provisions as the one category and escalation rates as the other category.

In terms of the fees and provisions category, allowance needs to be made for preliminaries and site management (this is activities such as supervision, foreman remuneration, scaffolding expenses, health and safety requirements, cleaning of the site), builder’s profit (the cost of the building material is at retail level and does not include the builder’s profit), contingency, demolition costs, professional fees, retention allowance (to ensure the quality of the work is compliant) and sundry fees.

In terms of the escalation category, allowance needs to be made for pre-construction escalation of building materials and labour as well as during construction. If your building was damaged partly or entirely by a fire you are going to have it rebuilt in terms of the same architectural design and not altering any structural designs of the building, then you can use your current building plan as basis and it will also not be necessary to apply to the municipality for any approvals. You will need to spend time in obtaining quotations from builders, analysing and appointing your management team etc. but this can be outsourced. The importance of making allowance for escalations is that building materials and labour can possibly increase during this reconstruction time either while you are sourcing builder quotes or appointing a management team as well as during the actual reconstruction period which can be a few months.

Once all these allowance has been by the surveyor, the final insurance value is arrived at as at Day 1 of Sum Insured. It is important to note that in both approach 1 (this approach) and approach 2 (the one here below), the final insurance value calculated is as at Day 1 of insurance. So in other words, if you insure your building based on our valuation regardless of whether we used approach 1 or approach 2, your building will be accurately insured for for today. But you need to keep the insurance valuation up-to-date with building cost inflation for tomorrow and next month and the month thereafter. What we normally do is to include in the report the estimated building inflation for the next year. You can then ask your broker to increase your monthly insured amount by this escalation percentage and in that way ensure that you are 99% insured at all times. Insurers normally include a 10% escalation clause in your insurance policy, but this can result in either over- or under estimating the insurance value of your building. The insurer is more than willing to take out this clause with specific reference to the buildings and to increase the insured amount based on the arrangement with your broker that in turn is based on our report. The only reason the insurer includes the escalation clause is because provision has to be made either by the client or by them, so if the client does not advise on the escalation they default to their escalation clause.

So in summary, the bill of materials and labour approach looks something like this:

1. Instruction to perform the insurance valuation;
2. Site survey of the building(s) including detailed measurements and photographs;
3. Research of current material costs and labour rates for your specific area;
4. Applying material costs and labour rates per building element;
5. Adding fees and provisions consisting of preliminaries and site management, builder’s profit, contingency, demolition, professional fees etc.;
6. Adding escalation rates for pre-construction and during construction;
7. Arriving at the insurance value as at Day 1 Sum Insured and Day 365 (the latter includes the escalation for the current year as discussed).

Approach 2 – Estimated cost

The second approach to determining the insurance value of a building is the estimated cost approach. This is also commonly referred to as the Estimated New Replacement Cost (ENRC, please see the “replacement cost versus reproduction cost” paragraph below). This approach is a summarised estimation approach to determining the value of a building and is not at the same level of detail as the first approach. It sees the building as an entity and applies a global replacement cost rate per square meter rather than a detailed bill of materials and labour.

The process starts by conducting a site survey (inspection) similar to approach 1, however, the level of detail of the building inspecting is slightly lower. Note is taken of the building design, fittings and finishes. For example, although the actual number of fittings in a bathroom is not counted and the type and number of windows is not measured and counted, note is taken of all the components of the building such as the type of floor covers i.e. whether it is tiles or timber or carpets etc., the type of windows i.e. whether it is aluminium, timber, steel etc., and the quality of kitchen counter tops etc. All these various components of the building is noted and photographed. Once the site survey is completed, the gross building area (GBA) is calculated to which a global cost rate is applied. For example, if the house has tile floors, standard kitchen cupboard with granite kitchen tops, aluminium windows, and a clay tile roof covering, a global replacement cost rate of R 6 500/m² can be applied to the building (or house) based on the gross building area (size of the building). The word global here means an all-inclusive rate. Once the gross estimation cost is determined, the surveyor still needs to add two categories of allowances, namely fees and provisions as the one category and escalation rates as the other category. In terms of the fees and provisions category, allowance needs to be made for preliminaries and site management, contingency, demolition, professional fees and sundry fees. Builder’s profit is not included as it is already included in the global rate per m². In terms of the escalation category, allowance needs to be made for pre-construction and during construction escalation similar to that in approach 1. Once all these allowances has been by the surveyor, the final insurance value is arrived at as at Day 1 of Sum Insured.

So in summary, the estimated cost approach looks something like this:

1. Instruction to perform the insurance valuation;
2. Site survey of the building(s) including less detailed measurements and photographs;
3. Research of current global replacement cost rates for your specific area;
4. Applying the global cost rate to the GBA;
5. Adding fees and provisions similar to approach 1, however excluding builder’s profit;
6. Adding escalation rates for pre-construction and during construction;
7. Arriving at the insurance value as at Day 1 Sum Insured and Day 365 (the latter includes the escalation for the current year as discussed).

Replacement cost versus reproduction cost

An important distinction needs to be made between replacement cost and reproduction cost as they are not the same. Replacement cost, in layman’s terms, is when a building is replaced with modern day equivalent building materials and not the original identical materials found in the building before the loss incident occurred. Reproduction cost, in layman’s terms, is basing the calculation on the exact reproduction and duplication of the building as it was i.e. the exact same building materials and quality of workmanship. Therefore, if you are insuring a historical building and the client wants it to be accurately insured, there is no other suitable option than the bill of materials and labour approach and reproduction as basis. If you are insuring a normal residential property, then either the bill of materials and labour approach or estimated cost approach can be used and replacement as basis.

Comparison of the two approaches

Depending on your context and specific needs, either of the two approaches or a blend may be suitable. Each approach has definite benefits and shortcomings that must consciously be taken into account when making a decision on which approach or blend of the two approaches will be suitable for you.

The benefit of the bill of materials and labour approach is that it is very accurate. If a fire should occur and the building burn down, you will be covered and paid out in full by your insurer. In the case of a fire, the insurer will send out their surveyor who will be using the bill of materials and labour approach to determine the insurance value for the entire building as it was before the fire and also the assessment of loss of that part of the building that was destroyed by the fire if the entire building was not destroyed.

The shortcoming of the bill of materials and labour approach is that it is time consuming and can be quite costly. Most clients are not sure whether they want to spend too much on a detailed valuation, but there is some aspects that you need to consider before making a decision. For example, let us say your building value is calculated by using the bill of materials and labour approach at R 2 500 000. The benefit is that in the case of a fire is that you will be paid out 100% of the R 2 500 000 and when you get quotes from builders to replace your building, it will cost you R 2 500 000. Therefore, you are in exactly the same position as you were before the fire incident and you do not need to put in any of your own capital.

The benefit of the estimated cost approach is that it is less time consuming and therefore more affordable in terms of the valuation fee.

The shortcoming of the estimated cost approach is that it is approximately accurate and not 99% accurate. One can argue that this approach is approximately 85% to 90% accurate while the bill of materials and labour approach is 99% accurate. The implication of this is that although you are saving on the valuation fee and monthly insurance premium, there is the risk of being under-valued and being paid out based on average in the case of a fire claim. For example, let us say your building is valued at R 2 000 000 based on the estimated cost approach but if the bill of materials and labour approach was used, the value would have been R 2 500 000. That means you are under-insured by R 500 000 or 20%. If the insurer would like to retain you as a client and depending on their leniency, they can pay out your insured value of R 2 000 000, but you will still need R 500 000 from your own capital to reconstruct the building. Insurers generally pay out claims if the difference between the actual insurance value of the building and what you had it insured at is up to 15%. If it is more than 15% they tend to apply average. That means that if you were insured for R 2 000 000, and a fire occurs and their surveyor says the value of the building should have been R 2 300 000, then they might still pay out your R 2 000 000 (as you are within a 15% value difference) but you will still need to fund R 300 000 from your own capital. What is likely, however, to happen in such a scenario is an average pay out by the insurer. That means if your building was insured for R 2 000 000, but in reality it should have been insured for R 2 500 000 (the difference being 20%), the insurer will pay out R 2 000 000 / R 2 500 000 * R 2 000 000 = R 1 600 000. Now you are not even getting paid out your insured value of R 2 000 000 but R 1 600 000 and in addition you will need to fund the difference between R 2 500 000 and R 1 600 000 which is R 900 000 from your own capital.

Although this might seem to suggest that if you want to be insured accurately one must at all times use the bill of materials and labour approach as that is the only approach that will guarantee you are paid out correctly and in full, that might not always be the case. For example, when dealing with historical buildings, often the need of the client is to have those buildings accurately insured with no allowance for variance as the buildings are worth a lot. In such a case, it would be better to use the bill of materials and labour approach as it will give you a true value of the building with little to no subjectivity or interpretation of value. If you are a normal residential home owner and just want your house to be approximately accurate in terms of insurance, then the estimated cost approach is suitable for you.The estimated cost approach is prone to some degree of subjectivity either in terms of the surveyor’s professional opinion of the rate per square meter or the client’s view of the insurance value of his or her property. In order to make a decision, you need to consider your own context and the degree of variance you can tolerate on your insurance value.