Everybody knows that insurance companies are the “King Midas” of today’s world. One of the reasons is that insurers often play by two sets of rules: one set when they are asking for rate increases, and another when they are paying out claims!
There are replacement cost assumptions made during underwriting that differ from the replacement cost assumptions made at the time a claim is presented. The difference in these assumptions creates a “statistically probable” windfall for the insurer.
The replacement cost of a building is by definition an aggregate of individual construction trade costs (such as drywall, electrical, roofing, etc.) that make up the whole. These construction trade costs include all costs incurred by the particular tradesman actually doing that work, including their sub-contractor overhead and profit margins (SCO&P). In addition to that aggregate replacement cost is the markup added to the process by a general contractor, who is paid for his time, expertise in management, and assumption of risk. In the insurance restoration world that markup is generally 10% for overhead expenses and 10% for profit, and in an insurance claim this markup is commonly referred to as the “10 & 10,” or “General Contractor Overhead & Profit” (GCO&P).
The windfall starts with the RCV calculations made during underwriting. These costs are generally calculated using software that assumes a number of things about a building. The software holding almost 50%of the market share is a program called 360Value, owned by Verisk Insurance Solutions. Until 2009 Verisk was wholly owned by several of the world’s largest insurers, including AIG, The Hartford, and Travelers. Verisk went public in 2009 in that years largest IPO, raising 1.9 billion for those owners. Today, over 90% of Verisk stock is held by only 374 institutional shareholders. The company’s board of directors contains a number of former insurance executives from some of the world’s largest insurers.
360Value software was developed by Xactware, a company that is also wholly owned by Verisk. Xactware is also the company that produces the Xactimate software.
Here is some info from the 360Value information brochure:
“From underwriting to policy renewal, you can count on the 360Value® replacement cost estimation system to generate reliable estimates for every property in your book of business. That’s because 360Value replacement cost estimates account for all costs needed to reconstruct a property to its original condition — down to the screws and nails. This true component-based approach for residential, commercial, and agricultural properties is what sets 360Value apart from other cost-estimating tools. The key to the accuracy and reliability of 360Value estimates is Xactware data and technology. Using Xactware’s comprehensive, current, and localized reconstruction cost information on labor and materials to calculate replacement cost estimates, 360Value helps you better manage risk and align underwriting coverage limits with expected claims losses. In fact, 360Value is the only replacement cost estimating system that uses the same building cost data as Xactimate®, Xactware’s industry-leading claims estimation solution.”
“Match the front end to the back end -”
Consistency across your underwriting and claims means no surprises for underwriters or policyholders in the event of a total loss. 360Value uses the same reconstruction cost data as the industry-leading Xactimate, which is used by:
• nine of the top ten U.S. property insurers
• 80 percent of insurance repair contractors
• seven of the top ten U.S. independent adjusting firms”
You can view the entire 360Value brochure by following this link:
During the underwriting phase of a policy 360Value or other software is used to establish an RCV for a structure. In that process an RCV is calculated for each component of the structure, and that value contains GCO&P.
See this link for a sample 360Value appraisal:
The aggregate RCV that is calculated for the structure is then used to establish the premium payment for the associated policy. In short, insurers collect premium dollars in anticipation of the cost to repair or replace covered property, and those costs anticipated include GCO&P.
At some point in the future a claim against this policy may be presented. It is at this point, however, that the cost assumptions for the loss often change, and GCO&P cost is no longer assumed to be a part of the loss.
Over 80% of all property insurance claims in the U.S. and Canada are settled on a software platform called Xactimate. As mentioned earlier, Xactimate is also wholly owned by Verisk.
Most claims presented are relatively small, and only require 1,2, or 3 of the various construction trades to restore the property to a pre-loss condition. It is at this point, and in these claims, that most insurers diverge from the GCO&P assumptions that were made while calculating premium. Instead, most insurers refuse to calculate GCO&P on these losses, claiming that they lack the complexity to require the services of a general contractor. In fact, many insurers cite a “three trade rule,” saying that they will not pay GCO&P on any loss that does not require more than three trades. Others simply deny paying GCO&P on losses that they arbitrarily feel are not complex enough to require the services of a general contractor.
So, looking at the example of the roof of the building in the 360Value sample report, we see that the roof is valued at $70,578.00 inclusive of GCO&P. Since GCO&P is generally considered to be 20%, we can infer that the cost of the roof used in that calculation from the roofing contractor is approximately $58,815.00. Consequently, when the owner secures an estimate to replace the damaged roof on his building in the amount of $58,815.00, that is all the insurer will pay even though the insurer has collected a premium on that risk based on an anticipated potential payment of $70,578.00.
The conversation is muddied by the concept of indemnification. If, in our example above, the owner secures an estimate for $58,815.00 and is paid that estimate plus GCO&P, then it is the owner that reaps an improper windfall.
The conversation is further muddied by the two avenues that loss values in an insurance claim arrive through:
- Estimates for repairs requiring 1, 2, or 3 trades are obtained by the property owner and agreed with by the insurer, and the claim is settled on that amount. Those estimates by definition contain the SCO&P (subcontractor overhead & profit) required by the tradesmen, but obviously contain no GCO&P. Adding GCO&P to that estimate would yield a windfall to the insured. The insurer is already reaping a windfall because they had calculated premium as if that loss was repaired by a General Contractor requiring GCO&P.
- An estimate for repairs is created “out of thin air” using Xactimate software, and no actual bid from any contractor is secured. The cost assumptions utilized by Xactimate software do not contain O&P for either the tradesman or a general contractor. This from an Xactimate whitepaper explaining cost assumptions inside Xactimate:
“When Xactware performs market research on unit prices, those surveyed are specifically asked to not include expenses that would be included in the General Overhead and Profit markup percentages (item #1 below).
General Overhead are expenses incurred by a General Contractor, that cannot be attributed to individual projects, and include any and all expenses necessary for the General Contractor to operate their business. Examples (including but not limited to):General and Administrative (G&A) expenses, office rent, utilities, office supplies, salaries for office personnel, depreciation on office equipment, licenses, and advertising. Including General Overhead expenses in an Xactimate estimate–General Overhead expenses are not included in Xactware’s unit pricing, but are typically added to the estimate as a percentage of the total bid along with the appropriate profit margin. These two costs together constitute what is normally referred to in the insurance restoration industry as General Contractor’s O&P, or just O&P. General Overhead and Profit percentages can be added in the Estimate Parameters window within an Xactimate estimate.” (emphasis added)
In the instance of #2 above, not applying O&P creates a double windfall for the insurer; both the non-payment of the SCO&P owed to the tradesman for his work, and the GCO&P premium portion collected for the GCO&P cost assumption during underwriting.
There is another area of windfall that is produced by this method of RCV calculation at underwriting, and that is Building Law & Ordinance coverage.
Current RCV calculations in 360Value or a similar software necessarily assume today’s costs, which include replacing the structure to meet current building codes. However, many structures today have various systems that do not meet current building codes, and those systems would have to be upgraded during the repair process should they become damaged, or the structure damaged enough to trigger an all-over “bring it up to code” mandate from the building official. For example, if damage to a building required re-wiring, and the existing wiring did not meet current building codes, then the new wiring would have to be upgraded to meet those current codes. In the absence of a Law & Ordinance endorsement however, it is likely that those increased costs would not be funded by the policy, even though premium had been collected in anticipation of those current and upgraded costs. That means that the property owner is paying premium for cost assumptions that will not occur in the absence of an endorsement, and then has to “double-pay” for the coverage in the form of an endorsement to actually secure the Law & Ordinance coverage.
In summary, insurers calculate premium based on more expensive risk assumptions than they are usually actually willing to pay at claim time.