Insurance Valuation Services TODAY - October 2010

October 2010
Volume 6 Issue 2

In this issue, we focus our attention on the difference between a desktop valuation and a valuation conducted with the benefit of an on-site inspection. We’re often asked about this difference, especially as the on-site service will be more expensive.  Here, we will focus on the insurance valuation of real property (buildings), as we have addressed personal property valuation using fixed asset records on a desktop basis in past issues of this newsletter.

The valuation of water and wastewater treatment facilities has evolved over the last 20 years, moving from a broad-based approach - $/gallons per day - to methodology focusing on individual operating systems and associated equipment.  We review past and present techniques and their effects on insurance underwriting.

Finally, we see that construction and equipment cost indices have stabilized, with little or no change over the last 12 months.
 

Desktop vs. On-Site Property Valuations

This article was authored by Nigel P. Wilson, ASA, VP & Managing Director, Insurance Services
 

A question that is posed to valuation consultants on a daily basis is:

Usually, this is closely followed by: 

Often, this pertains to differences between desktop and on-site valuations of insured real property (buildings), as numerous reliable tools are available for desktop valuation of these assets.  However, to use any tool effectively, you must be aware of its limits.  Hence, when considering desktop valuation of buildings, ask yourself whether sufficient data is available to address the following:

1) The accuracy of available square footage data
During an on-site inspection, the appraiser will accurately determine the building area.  This is critical - all cost estimating programs are based on the square footage area, or volume, of a building.  If the area is incorrect, the value conclusion will be wrong.  Typically, the areas for buildings that are initially available are low; they may not account for irregular shapes, all floors, or wall heights.  Areas provided may be net as opposed to gross, especially when dealing with commercial office or retail space.  In our experience, even the areas provided in loss control surveys are low by 10-15%.  If the areas are less than actual, they will result in an artificially high $/SF when divided into the current insurable value, perhaps giving a false sense of security.

2) Identification of construction materials
Incorrect choice of materials when using construction estimating software can change the final conclusion significantly.  This includes the correct determination of construction (ISO) class, as well as the actual construction materials.  At a minimum, a set of as-built plans should be used in a desktop valuation.

3) Quality of construction
All construction estimating programs have built-in quality ratings and default settings that can be adjusted to account for superior or inferior quality of construction and materials.  This is a subjective decision based on property inspection and consultant experience, and can make a significant difference - sometimes 12–15% from average to above average - in the final value conclusion.

4) Appropriate model usage
Sophisticated construction estimating programs have many different models to choose from, and it is often difficult to choose the appropriate model.  In the Marshall & Swift - Building Valuation System, one of 20 different model occupancies could be chosen for a manufacturing facility.  In some instances, an on-site inspection might indicate that it is appropriate to allocate different portions of a building to different models, e.g., 20% to office, 30% to manufacturing, and 50% to warehouse.  Just what is the difference between a desktop and an on-site valuation?  I assume that the on-site valuation will be more expensive; why should I pay extra for this?

5) Additional building features
Many special features are not included in a basic model building in construction estimating software and can only be determined from an on-site inspection.  Examples of additional features include elevators and escalators, security systems, architectural finishes, and clean rooms.  It is important to review the description of the model, and then add feature(s) not included.

6)  COPE data
A site inspection facilitates collection of accurate primary and secondary property construction, occupancy, protection, and exposure (COPE) data, which may not be readily available for use on a desktop basis.  Primary COPE data includes:

The accuracy and completeness of COPE data provided is often out-of-date and unreliable.  Therefore, we emphasize inspecting properties and independently compiling COPE data.  In addition, our clients receive access to their data via a secured website with eRISK, our robust property insurance underwriting analysis and risk management software..

7) Site-specific factors
Site-specific factors, which can add to or subtract from construction costs, will not be discovered without a site inspection.  These factors can include:
 

8) Building shape and perimeter
Cost estimating software models are based on rectangular buildings; when a building varies from this shape, it becomes more expensive.  Hence, the total perimeter is an important component in estimating the insurable value of any building.
 

Personal Property or ContentsThere are two accepted approaches for estimating the insurable value of personal property on a desktop basis:

Modeling is based on past fixed asset inventory and valuation experience of similar properties, and the application of an appropriate $/SF rate.  Successful contents modeling is based on a reasonable sample size of similar properties that have been the subject of on-site inspection and valuations.  This technique is best applied to occupancies where the personal property insurable values are relatively low compared to the real property values, and where there is little variation in the makeup or concentration of personal property.

We’ve addressed trending historical costs in previous publications.  Click here to read our monograph titled “Concluding insurable values by trending historic costs”.

Summary
A desktop valuation is a useful tool for identifying or red-flagging suspect insurable values.  However, considering the unpredictable quality of available data, it needs to be used within its limitations, and should not be used for underwriting insurable values.  American Appraisal recommends that an on-site inspection and appraisal be conducted every five to seven years.
 

Water and Wastewater Treatment Plants
Appraisal Approach and Methodologies

Introduction
We recently compared and contrasted past and present approaches to the insurance valuation of water and wastewater treatment facilities, and felt that this would interest a wider audience.

Traditional Approach
Traditionally, the macro approach, which entails determination of insurable value based on a total plant average daily capacity in gallons per day (GPD), has been used.  Cost per gallon varies with overall plant size, and is based on an average plant with primary and secondary treatment facilities.  A range of $/GPD is available depending on overall capacity.  However, it is difficult to determine the appropriate $/GPD within the range supplied and to adjust for specific plant features, especially if the plant has tertiary treatment or other significant attributes that add to or detract from the value of an “average” plant.

Preferred Methodology
The preferred methodology dictates valuation of individual assets or process systems by building.  Rather than determining an overall cost based on total capacity, cost is built up by process unit.  Typical process units might be:

Detailed information (manufacturer, model, size/capacity, etc.) is taken regarding the major equipment within each process and used to develop the insurable value based on a cost build•up approach.  Allowances are then made for instrumentation, controls, valves, process piping, design and engineering, installation, and indirect costs.

Inclusions/Exclusions
Historically, foundations, below-grade (piping, wiring, etc.) assets, and some retention ponds were classified as exclusions; it was believed that these assets would not be damaged in a loss, and hence not subject to repair or replacement.  Underwriters have since realized that such assets can be damaged and now use total reproduction cost, without deduction for any exclusions, as a basis for premium calculations.

Not all policies are the same, and inclusions or exclusions should always be determined by the broker or risk manager and communicated to the valuation consultant to ensure an appropriate insurable value conclusion.

Is it Real or Personal Property?
Opinions differ as to the demarcation between real (buildings) and personal (equipment) property within water and wastewater treatment facilities.  When these facilities were valued by the overall GPD capacity and a single insurable value was determined, there was little room for interpretation.  Now, with facilities valued by process unit, a split between real and personal property becomes possible.  In areas subject to natural catastrophes, it can be critical to split the risk associated with real and personal property, requiring a more detailed inventory of the personal property.

• Buildings (four walls, roof, floor[s], with electrical and mechanical services)
• Civil construction (cast-in-place concrete tanks/vessel/ basins/chambers)

• Equipment (pumps, motors, controls, valves, blowers, screen, rake mechanisms,filter presses, centrifuges, mixers, bar screens, etc.)

Areas open to discussion include fabricated metal tanks, which perform the same function as a cast-in-place concrete vessel.  It is important to ensure that all parties (underwriter, insured, and valuation consultant), agree how the assets are segregated between real and personal property.

Additions to Treatment Facilities
Water and wastewater treatment facilities are rarely static; as communities grow, so do they.  Plants are designed to anticipate future growth, and typically built in phases.  However, when an addition is made, existing structures and systems undergo some reworking.  Hence, if the costs of additions are added in their entirety to insurable values, the values can exceed the actual cost of reproduction.

Construction Cost Indices

After two years in which we saw construction costs increase and then decrease significantly, a period of stability appears to be taking effect.  For the past two quarters, construction cost indices have experienced zero or somewhat positive changes.  Material prices appear to be bouncing back, with steel rising from a low of $575 per tonne in May 2009 to reach its current rate of $735 per tonne.


Note:  The range of change shown by Marshall & Swift represents different classes of construction.

Always remember that cost indices are just average indicators of change; they are not absolutes, and there is no “average” building.  After five to seven years, you should establish a new replacement cost basis by using a qualified valuation consultant.

Equipment Cost Indices

Equipment cost indices have not shown the same volatility as construction cost indices; however, they have also been affected by the economic downturn, and cost changes have been flat over the past 12 months.

Take care when selecting an index to track the rate of cost changes for your company’s capital equipment.  The three indices shown below all track average capital equipment cost change percentages, and indicate the differences that have occurred over the past three 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.

Sources

¹ Engineering News Record, Monthly Construction Economics Report, July 2010
² FM Global, Industrial Cost Trends, July 2010
³ RSMeans, Construction Cost Indices, 30-City Average, July 2010
⁴ Marshall & Swift/Boeckh, Marshall Valuation Service, Quarterly Cost Index, July 2010
⁵ U.S. Bureau of Labor Statistics, Producer Price Index for Finished Goods - Capital Equipment Non-Seasonally Adjusted, July 2010