In Builder’s Risk insurance, a critical concept to grasp is the “term to value” issue, often regarded as the black sheep of the “insurance to value” family. It’s not glamorous, and no one really wants to talk about it, but in challenging portfolio classes it is essential for achieving accurate pricing and managing exposures.
Not How the Actuaries Intended
Too often an insured or broker might say, “We don’t want to cover site work; there isn’t much exposure.” We agree! (And we’ve already thought of that…) Builder’s Risk rates are developed by actuaries who assume the rate should cover the whole shebang, from the moment the bulldozers roll in until the last nail is hammered. During the initial phases of construction, exposure is typically low, gradually escalating as the project progresses. Consequently, while the rate associated with the early phases is relatively small, the entire term needs to be considered in the overall pricing. From an actuarial perspective, rates are developed based on a build up of values over the course of a project term. Look at it as a growth chart – starting at 0 from minimal values/site work with the line gradually curving up throughout the different phases of construction and peaking at the end, signaling maximum exposed values. Rates must be inclusive of all values throughout the project term (even when excluding site work) for them to be an accurate weighted average and premium adequate for the overall exposure.
Excluding the initial construction phase shouldn’t be seen as a cost-saving measure. The full construction term, as outlined in the project’s timeline or Gantt chart (which is why underwriters ask for them…), is used as the basis for rating. Shortening the term by removing phases like site work or foundation typically results in inadequate pricing, much like undervaluing property. With this being said, exceptions do exist and should be taken into consideration by the underwriter. A common example would be if the site work phase is unusually long.
The Pitfalls of Shortening the Policy Term
Removing the first phase of construction is like asking to only insure the second story of your house. It doesn’t work that way. Primarily, the industry does experience site work losses. Atmospheric rivers causing flooding, cracked utilities and foundation settlement are all real-life claim scenarios.
Additionally, binding coverage when a project goes vertical can introduce several drawbacks. These projects may be considered “prior-starts”, limiting available capacity and potentially increasing overall pricing. Furthermore, you’re also rolling the dice that the market might exclude your foundation if that work has already been completed. While this might save on premiums, the complications from a claim can outweigh the savings.
Let’s also not forget the chaos this can cause with CAT modeling. Builder’s Risk CAT models contemplate a buildup of values, typically making results more favorable than the standard property ones. Excluding the initial construction phase tends to throw these model analyses off.
Another critical consideration is the impact on the period of indemnity for delay losses. The delay period cannot extend beyond the policy term. So, if you have an 18-month project but only buy a 15-month policy, you may run into a scenario where you have 18 months of delay exposure but can only recover for 15 months.
Determining the Start Date for Full-Term Coverage
If coverage is bound when the project goes vertical, determining the start date for the full term is crucial. The technical answer is that coverage should be bound at site mobilization. This essentially marks the start of site work, but adjustments can be made based on the average term. For projects with abnormally long site clearing or grading phases, such as single-family home developments, a reduced rate might be applied to the initial site work phase with a standard Builder’s Risk rate for the vertical construction.
Understanding these intricacies of Builder’s Risk insurance helps ensures that projects are adequately covered, mitigating potential risks and financial exposure. Properly addressing the term to value issue is key to achieving accurate pricing and avoiding the pitfalls of inadequate coverage.
