Insurance Valuation Services TODAY - February 2012

February 2012
Volume 7 Issue 1

In this issue, we focus our attention on whether a proposed, ongoing or completed fair market value or fair value engagement can also be used for insurable values. While this question is typically raised during or after a valuation project, it should be addressed during initial scope discussions to find the best solutions for all parties. We would like to thank Tim Ramsayer, Senior Managing Director of American Appraisal’s industrial valuation practice, for his input on this article.

In addition, we see that construction and equipment cost indices have stabilized during the past 12 months, and we highlight the importance of choosing the appropriate personal property indices.
 

Responding to Insurable Value Requests in a Fair Market Value (Fair Value) Setting

We are often asked whether a proposed, ongoing or completed valuation project can also be used for insurable values.  This question typically arises from tax and financial reporting managers, risk managers or insurance underwriters.

When asked this question, it is important to first gain a thorough understanding of the property insurance need, and then to consider how the existing valuation work could be used toward a property insurance service.

When evaluating the property insurance need, consider the following:

• If a client needs to present detailed insurable value data to an underwriter or rely on the data for specific property insurance placement, the typical data that is developed and presented as a direct byproduct of, say, a fair value service may be insufficient or different from what is required in actual underwriting situations.
   
• If a client is simply trying to capture whatever data might be available from, say, a fair value service, in order to better assess if a more complete insurable value analysis is warranted, it is more likely that some relevant data can be extracted and summarized for this type of review, at minimal or no additional cost or effort.

With respect to leveraging work effort to serve an insurance service, it’s equally important to consider if and how the work effort performed and/or results obtained for an original service, say fair market value (fair value), can be leveraged to serve additional client needs.

• For instance, in a federal tax or financial reporting setting, in which fair market value (fair value) estimates for tangible assets are often developed for purchase price allocation needs, this question raises the necessity to review the anticipated scope of service, methods and procedures, and approaches to value.
   
• The question could also come from a risk manager who learns that a fair value study was completed for a recent business acquisition. In that situation, the risk manager would likely ask if there was some replacement cost data in our fair value work files that could be extracted and used for the client’s insurable value needs. Again, this would require a review of the original scope of service that was performed, as well the approaches to value and methods and procedures used.

Review of the scope of service, approaches to value, and methods and procedures is needed because these variables can vary significantly depending on whether we are developing replacement cost estimates for a property insurance service or fair market value (fair value) for federal tax (financial) reporting. Some of the variances include:

• Amount of site inspection work performed
  
  -   For a fair market value (fair value) service, the amount and extent of site inspections can vary from the inspection of all assets to no inspection of any of the      assets. For insurance services, an inspection of all assets is generally preferred, if not required, for underwriting purposes.

• On-site procedures and targeted data gathered during site inspections
  
  -   On-site procedures for an insurance service focus on the variables that would help to refine the replacement cost estimate, whereas with a fair market value (fair value) service, on-site procedures focus on collecting the data that will most impact the fair market (fair) value estimate, with less focus on a replacement cost estimate.

-   On-site procedures for insurance services tend to focus the data gathering on identifying and matching individual assets to specific locations within a building or facility. This is typically important for underwriting, but is not normally important and is not done for tax and financial reporting.

• Use, or nonuse, of the cost approach

 -   Not all fair market value (fair value) analyses involve the cost approach; if the cost approach is not used, replacement cost data would not be available. When a fair market value (fair value) service is not expected to use the cost approach or use it on a limited basis, adding an insurable value need will necessitate additional work effort to develop the supplemental replacement cost estimates.

-   If the cost approach is used for a fair market (fair) value service, reproduction cost, replacement cost or functional replacement cost estimates may be developed. Therefore, on any given project, the cost approach estimates developed may be inconsistent with the replacement cost estimate required for an insurance service.

-   For a fair market (fair) value service, the assets (or groups of assets) analyzed using the cost approach may be aggregated for analysis and reporting purposes more than what would be preferred for an insurance service, which may require more granular asset delineation.

• Confirmation that the assets analyzed for the original service are the same that need to be analyzed for a different service

-   For an insurance service, what should be included/excluded in the insurable value estimate could vary significantly from inclusions/exclusions for a fair market (fair) value service. Examples of assets that would be included in a fair market value (fair value) setting, but would potentially need to be excluded from an insurance service, are land, assets located underground, licensed vehicles and computer software.

-   An insured may be required to insure the real and/or personal property assets that are owned by others and leased to the insured. This type of replacement cost data would not typically be available from a fair market value (fair value) service.
-   A fair market value (fair value) service may exclude some assets entirely, or rely on limited means to complete an analysis of certain assets. This could happen when assets are identified as held for sale, when reliable data is not available, and/or when the asset (or group of assets) is less material to the overall valuation. In these situations, either no value is assigned or net book value may be used as a proxy for fair value. Neither situation would yield usable replacement cost data for an insurance service.

If this question arises at the onset of a fair market value (fair value) service, there are many ways of addressing the additional insurable value service need. However, if this question is posed after the conclusion of a fair market value (fair value) service, understanding the scope of service, the methods and procedures used, and the approaches to value applied should help risk managers better determine if and how they might leverage extracted data from a fair market value (fair value) service. In either situation, an appropriate response would be, “Let’s discuss – we’ll figure out the right solution for your insurable value need.”
 

Insurance valuation reports include a Building Inspection and Appraisal Report as shown above. Please click here for more details.
 

Inflation Tracker: Construction Costs Stabilize
 

Take care when selecting an index to track the rate of cost change for your company’s capital equipment.  The three indices in the table above all track average capital equipment cost change percentages, and indicate the differences that have occurred over the past four years. Developers - as well as insurance brokers, underwriters and valuation consultants - can all recommend appropriate indices for your particular facilities. Select one that represents your capital equipment as closely as possible; there are significant differences between the average indices shown here and specific industrial-sector indices. As an illustration (Figure 1), it is interesting to compare how the above three average indices have tracked since 2000.		Figure 1
Note the spread of increases - from 16.5% to 42.5%. This is caused by each index tracking a different market basket of goods, which is amplified when average indices are compared. When comparing indices for a specific class of equipment, the range of increases should be much narrower. As an example (Figure 2), we have compared four indices that track chemical process and oil &gas manufacturing equipment: This chart shows a range of increases of 44.4% to 58.1%, much tighter than the average indices. You will also notice that chemical process equipment has increased in cost at a much greater rate than average equipment, emphasizing the fact that when using indices, you should select one that represents your capital equipment as closely as possible.		Figure 2
Always remember that cost indices are just average indicators of change; they are not absolutes and there is no average building or average assemblage of equipment. After five to seven years, you should establish a new replacement cost basis by using a qualified valuation consultant.

Sources

1. MEPS (International), Ltd, All carbon steel products composite price and index
2. Engineering News Record, Monthly Construction Economics Report
3. FM Global, Industrial Cost Trends
4. RS Means, Construction Cost Indices, 30-City Average
5. Marshall & Swift/Boeckh, Marshall Valuation Service, Quarterly Cost Index
6. US Bureau of Labor Statistics, Producer Price Index for Finished Goods -Capital Equipment Non-Seasonally Adjusted
7. Oil & Gas Journal, Nelson/Farrar total refinery index
8. Chemical Engineering magazine, Chemical equipment total index