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By STEVEN GOTTLIEB, MAI, MRICS, senior manager, Deloitte Financial Advisory Services LLP; NATHAN FLORIO, senior manager; and THOMAS HOFFMAN, manager

In calculating insurable value for a property, there are no standard rules or valuation methodologies. The methodology used to estimate insurable value must be consistent with the parameters of the insurance policy, not necessarily what the market value is.

Consider an insurable value estimate of a suburban office building from a financing appraisal, wherein the appraiser reports market value at $350 million and insurable value at $189 million.

Because the insurable value estimate is contained within a report that also estimates the market value of the same property, the assumption is that the insurable value estimate is appropriate, even though the appraiser didn't develop market value based on the cost approach. Often, the only connection between the insurable value and market value estimates is that they are both in the same report.

A review of the insurable value estimate from the appraisal would reveal: one, a potentially incomplete cost analysis, and/or two, potentially problematic "implied" land values.

An analysis of the insurable value estimate indicates that the appraiser omitted and/or underestimated certain line items, per Table 2 and Table 3. A more reasonable cost estimate is presented in the "Corrected" column.

Even a cursory review of the insurable value estimate reveals shortcomings, but because the appraisal presents only the first column (i.e., the $210 million), it is (incorrectly) assumed to be appropriate.

Further, while the insurable value estimate does not require a land value estimate, we can calculate the "implied" land value by deducting the insurable value from the market value estimate from the same report.

If the insurable value is assumed to be appropriate simply because it was prepared by the same appraiser that estimated the market value and the two estimates are contained in the same report, then it stands to reason that the implied land value (i.e., the difference between the two values) should also be appropriate. In our example, the market value is $350 million and the insurable value is $189 million, implying a land value of $161 million.

However, research into local land sales reveals that land value is more appropriately between $50 million and $60 million, rather than the $161 million implied by the appraiser's market and insurable values. If the implied land value is grossly overstated, it follows that the estimated insurable value is grossly understated.

RECONCILIATION

Appraisers preparing insurable value estimates and the users of appraisal reports should attempt to reconcile the two estimates when they are contained within the same report. Developing the insurable value estimate into a full-cost approach (which can then be reconciled with the other valuation approaches) would identify any issues with the insurable value.

An attempt at such reconciliation is found in the following table (Table 3). The first column reconciles the appraiser's estimated insurable value with the market value; the "Corrected" column presents the same reconciliation using appropriate cost and land estimates.

For the appraiser's insurable value to reconcile with the market value, the land value would need to be $161 million. However, the market indicates land value is more likely closer to $50 million.

In this case, insurable value is underestimated by $108 million (the difference between the initial $189 million depreciated cost and the "corrected" $297 million depreciated cost).

Without a thorough analysis of cost items and comparison to market value, an insurable value estimate is likely to be severely understated. Note that the example was not developed to illustrate that the insurable value estimate should be equal to market value. Rather, there should be some relation between the insurable value estimate of the improvements and the market value of the overall property, especially when these values are prepared by the same appraiser and presented within the same report.

Not all owners rely on the appraisal's insurable value estimate, or even the carrier's estimate.

"Insurance carriers will increase insurable value by some factor (each year)", reported Bill Motherway of Tishman Construction. "We do (an internal valuation) each year, then check the results against the carrier's estimate, and if the internal estimate is within a few percentage points, Tishman Construction will accept the carrier's estimate. Further, every four to five years, Tishman gets an appraiser to revalue the assets."

Conventional valuation concepts familiar to most appraisers are not necessarily the same as insurance-related valuation concepts, and owners should confirm that the preparer of an insurable value estimate understands the differences.

REBUILD CONSIDERATIONS

Another overlooked valuation issue is that the current structure may not be replaceable following a loss. This is especially concerning in older buildings, where three factors can cause increased rebuilding costs:

1. Original materials are no longer available.

2. Changes in building codes may necessitate a different rebuild than the original construction, likely at an increased cost.

3. Market changes may necessitate a different rebuild. Will the policy cover these additional costs?

When it came to rebuilding the World Trade Center, public scrutiny required the Freedom Tower and adjacent buildings to include additional stairwells, areas of refuge in case of future catastrophic events, improved egress and a blast-wall system.

"Whenever you have a building that is old, high-profile or totally destroyed, you need to think if the insurable value captures the cost to rebuild in the event of (a) disaster," said Mark Davidson, senior counsel at Proskauer Rose LLP.

The real estate industry needs to better understand the exclusions, premises of values and coverage limits of their policies. They should confirm that insurable values have been estimated based on appropriate methodologies and assumptions, preferably by professionals experienced in performing insurable value estimates.

Risk departments should ensure that the appraiser has an understanding of the firm's insurance policy and applies this knowledge to the valuation. Companies should move away from the current practice of using the insurable value estimate prepared for the financing appraisal to set the limits of their property damage coverage.

May 1, 2009

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