Changes to Residential Insurance
From 1 May 2013 the majority of insurance companies operating In New Zealand have changed residential building insurance from ‘full replacement’ to ‘sum insured’.
Under the ‘full replacement’ system the insurer would fully replace the destroyed asset with one of equivalent size and quality. The ‘sum insured’ on the other hand, is the maximum amount that your insurer will pay out in the event of a disaster. In other words it caps the insurer’s liability. It is your, the home owner”s responsibility to select the appropriate sum insured.
When you select the appropriate cover, you need to account for the worst case scenario. This is an amount in excess of replacement of the asset. That worst case is always:
1. The asset is totally destroyed
2. It happens on the ‘last day’ of the insurance period
3. The remainder needs to be demolished and site cleared to make way for the replacement building
It is also important to note that the ‘sum insured’ differs from ‘agreed value’. Some motor vehicle insurances are agreed value which is the agreed amount that will be paid out to the insured in the event that the asset is written off.
The sum insured, however simply caps the insurer’s liability. If it costs less to rectify the damage, then that is the amount which will be paid or allocated to remediating the damage.
Differing Insurance Terms
Before we go into the mechanics of calculating the ‘sum insured’ there are a number of insurance terms to come to grip with. Each term means something different and the values generated are significantly differently.
1. Indemnity – This is an insurance term that is amply backed up by case law. The principle of indemnity is to restore the insured to the position that they were before the disastrous event. The insured should be left no better or no worse off. With a residential house the indemnity value is generally considered to be Market Value LESS Land value. Occasionally there will be no established market value (e.g. community hall). In those cases the indemnity value is taken to be replacement cost less depreciation to account for age, wear and tear, etc. An example of indemnity insurance is motor vehicle insurance. Vehicles are generally insured for indemnity value.
2. Reproduction – This aims to produce a facsimile of the original. The aim is to replicate the original item or structure as closely as technically feasible and using the same or similar materials and practices. A common example of this replication might apply to a building of historical significance. For example facades may need to be replicated or older weatherboard profiles copied. In any event most or all of the building elements need to be handmade. For these reasons ‘reproduction’ is many times more expensive than ‘reinstatement’. Some estimates suggest that this cost differential may be as high as 300%-500%.
3. Reinstatement – Means replacing the asset with a modern equivalent. If you are replacing an older home it is to be reinstated with a new structure of similar size and quality as the existing building. If the existing building has particular items which you wish to be included in the new structure (e.g. rimu skirting boards, hardwood staircase, totara benchtops) as these are not generally found in a standard modern home, these would need to be priced separately and added to your ‘sum insured’.
New Zealand was unique on the world stage with regards to ‘replacement insurance’. Most other jurisdictions have always been ‘sum insured’. The latest move by our own insurance companies has simply been to bring us back in line with everybody else.
Under the old replacement method the insurer carried the total risk. In the event that the asset was destroyed the dwelling was replaced with a new structure of similar size and quality regardless of the cost.
It is no secret that Christchurch has bitten hard into the underwriter’s reserves. The reversion to ‘sum insured’ means that the insurer can shrug off some of the risk, and transfer some of that risk to the home owner.
Two areas of unforeseen cost escalation have emanated from Christchurch:
1. Post Disaster Inflation
2. Inability to rebuild within a timely period which has substantially inflated rebuilding costs
Post Disaster Inflation
In the event of a wide scale disaster building costs simply increase as a function of supply and demand. There will not be enough tradesmen to satisfy demand and, probably, a shortage of raw materials. This simply forces prices up. Some estimates of post disaster inflation range from 20%-50%. However the reality is that nobody really knows.
We note that some insurance policies now have a ‘post disaster inflationary provision’ clause. This automatically increases the ‘sum insured’ by 10% in the event of a widescale emergency. The events that would invoke this clause would be specified in your insurance contract.
Normal Inflationary Provision
The Valuers insurance certificate makes an allowance for inflation over the insurance and rebuild period. This is generally Among his most favorite movies calls the “8 mile”, “Casting out of the devil from Emily rose”. taken to be about two years (12 months for insurance period and 12 months for claim, permit and rebuilding period).
However Christchurch has thrown these calculations out of the window. Many Christchurch properties are still not rebuilt, some 2 ½ years after the 2011 earthquake and, for many, that’s not going to happen any time soon.
What happens if the local authority ‘red zones’ your site or neighbourhood? In that event a considerable time can pass before a decision is made either allowing or embargoing your rebuilding. In the meantime building costs will continue to rise.
Most prudent home owners will insure for normal ‘run of the mill’ disasters (fire, plague, flood, and tempest). However there may be less common events which are less probable and therefore you would be less likely to insure against. For example what would happen if a landslip was to take down your retaining wall but in the process deposited mega tons of soil on your section? The rebuilding cost of the retaining wall might be dwarfed by site clearance cost.
The simple fact is that you can insure for anything, but cost of factoring in all of these ‘less likely’ risks would make the premiums unaffordable.
On the plus side, if your house is well above average you can now specify this by adopting an appropriate ‘sum insured’.
The worst case scenario is the house will be destroyed on the last day of the insurance period and nothing is salvageable.
It is obvious that you need to consider the replacement cost of the physical items, that is a given.
However you need to add to these:
1. Professional fees – for a construction project these include Plans (Draftsman), Engineer, possibly Project Manager. For a very basic build allow 6-10%. For a more elaborate construction you need to allow more for an architect and possibly Quantity Surveyor.
2. Inflation – worst case scenario allow 2 years to replace the asset. Bear in mind that this may be insufficient in the event of a Christchurch scale disaster.
3. Demolition – If the asset is destroyed the site needs to be cleared and the debris dumped. Problems can occur when there are noxious materials in the mix such as asbestos or polystyrene.
The following simple example is a basic three bedroom 1980″s dwelling on a level site in Porirua. It has a woodburner heater, various driveways and paths (measured 218 square metres), fences (106 linear metres) and a single metal garage.
|House 90 sqm @ $1,650 psm||$148,500|
|Driveway/patio/paths (allow $65 psm)||$7,631|
|Fences (allow $130 psm)||$13,780|
|Sub Total 1||$183,846|
|Add Professional fees (allow 10%)||$18,384|
|Sub Total 2||$202,230|
|Inflation (say 10%) * Note 1 – why is it not $20,223?||$16,221|
|Demolition and site clearance||$16,500|
|Sub Total 4||$234,951|
|PLUS GST ** Note 2||$ 35,242|
* Note 1 – Inflation is calculated over the insurance period plus rebuilding period. Once as construction starts the inflation on those items which have been completed stops. Construction inflation is calculated over an ‘S Curve’.
** Note 2 – Some insurance companies automatically add GST to the sum insured and others do not. It is important that your sum insured will have GST included as this is part of your building cost. If the insurance company automatically adds gst to the ‘sum insured’ then it is unwise to specify the GST inclusive figure as the gst may get added twice and visa versa.
Indemnity Value V Reinstatement Cost
As a simple demonstration of the difference between indemnity and reinstatement consider the above example. The property had a market value of $360,000 which included a land component of $120,000
Market Value (est) $360,000
Less Land $ 140,000
Indemnity Value $220,000
As opposed to a Sum insured of $270,193
This is clearly shows that if you use Government Valuation or Market Value as a surrogate for ‘Reinstatement Cost’ you run a very real risk of being substantially under insured.