If it sounds too good to be true: Cost Segregation Studies as a Means to Reduce Insurance Premiums
It was brought to my attention that a few CPA’s and Cost Segregation consultants are promoting changes in asset classifications and contractual risk transfer as a means to dramatically reduce property insurance premiums.
I have reviewed these claims and I don’t find them to be credible.
The primary benefit of the strategy proposed is that the landlord could reduce his property insurance premium by reclassifying various building components as personal property and transferring responsibility for these newly classified building components to his tenants. In order to be a viable strategy, many parties would need to change their definition of personal property, and the overall cost of the insurance for all parties would need to be decreased: neither condition is met.
In theory, manuscript wording could be drafted for the change in definition of personal property, but this process would:
1. require time and effort to draft and get approval for the language from the landlord, every tenant, and all of their respective insurance carriers, and be consistently applied to all of their lease agreements and insurance policies (which will be different for every property in the portfolio);
2. limit the markets willing to quote the insurance (decreasing competition and increasing costs) for the landlord and all tenants;
3. need to be repeated at every policy renewal for the landlord and all the tenants (and they all have different expiration dates throughout the year);
4. not be available for many tenants, since manuscript wording is realistically available only for large accounts;
5. unnecessarily complicate any loss adjustment (delaying payment to the landlord and tenants).
All of these parties have legal counsel, and any one of the lawyers could take issue with the concept. Given that the change is material and there are likely few (if any) legal precedents to rely upon, expecting to get universal or even majority acceptance would be overly optimistic.
If the insurance responsibility for the newly defined building components was contractually transferred to the tenants, the tenants would expect a reduction in rent equivalent to their increase in premium.
Unless the tenant has a lower rate than the landlord, there is no savings.
§ In general, “Personal Property” is more damageable and is charged higher rates than “Real Property” for the same location.
§ A typical tenant can’t afford a deductible as large as the landlord. Beyond the higher rate associated with the personal property risk, a rate premium for the smaller deductible would also be added.
§ Landlords would have to reassume the personal property risks during all vacancies, creating a policy administration challenge and a high probability of errors and gaps in coverage.
§ Even if the gap in coverage was closed by an Error & Omission coverage extension, the landlord’s loss history and relationship with the carrier would be materially damaged by any loss.
§ There would be no net insurance savings for a landlord and tenants associated with the proposed risk transfer.
Landlords following the proposed risk transfer strategy would be viewed as having higher total costs and more difficult to do business with. This coupled with significant administration costs and unnecessary increases in risk of coverage gaps makes the proposed strategy ill-advised and impractical.
Another claim being made is that premiums can be reduced by excluding the values of foundations and various site improvements.
As respects foundations, it’s not a good idea to exclude them from coverage or valuation.
For most commercial properties, foundations are covered, either in the basic form or by endorsement.
The coverage extension is not expensive and often needed.
In a large loss, it can be difficult and/or impractical to salvage the foundation.
§ Preserving the foundation during demolition and debris removal adds time to the reconstruction project.
§ Re-certifying the foundation also adds time.
§ There will be liability issues for the new contractor.
§ If the foundation can’t be saved, the insured wouldn’t have adequate coverage limits to fully recover.
As respects to “land improvements”, the alleged benefit of extracting their values would only be realized if it were true that the value had been erroneously including in the first place. This is rare, so no benefit would be expected by excluding them. Other than nominal “throw-in” limits, these have to be added to get coverage; additional premium (if any) is charged against the limit.
Additional Comments:
The cost basis used for cost segregation analysis is not the same as what is used for insurable value calculation. I would agree that detailed building characteristics catalogued during a cost segregation field survey can be used as inputs into a high quality insurable value calculation. However, I believe there would be issues with using the cost estimates from cost segregation studies for insurance purposes: specifically “new construction” vs. “reconstruction” basis for the data. Using “new construction” based values will increase the risk of inadequate limits and/or coinsurance penalties.
Questions for advocates of these strategies:
· What experience/training does the consultant have with insurance program negotiation, underwriting, or loss adjustment?
· What clients have successfully used this approach?
· Which carriers and/or brokers support this approach?
· What claims have been satisfactorily adjusted?
I welcome your questions and comments.