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.
Bill of materials and labourThis 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.
So in summary, the bill of materials and labour approach looks something like this:
Instruction to perform the insurance valuation;
Site survey of the building(s) including detailed measurements and photographs;
Research of current material costs and labour rates for your specific area;
Applying material costs and labour rates per building element;
Adding fees and provisions consisting of preliminaries and site management, builder's profit, contingency, demolition, professional fees etc.;
Adding escalation rates for pre-construction and during construction;
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).
Estimated costThe 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.
So in summary, the estimated cost approach looks something like this:
Instruction to perform the insurance valuation;
Site survey of the building(s) including less detailed measurements and photographs;
Research of current global replacement cost rates for your specific area;
Applying the global cost rate to the GBA;
Adding fees and provisions similar to approach 1, however excluding builder's profit;
Adding escalation rates for pre-construction and during construction;
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 costAn 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 approachesDepending 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.
http://capevalue.co.za/2015/04/building-insurance-valuation-methodology/