Paying the Price: The Status and Role of Insurance Against Natural Disasters in the United States (1998)

EUGENE LECOMTE

THIS APPENDIX DESCRIBES the insuring of commercial property against natural hazards such as earthquakes, windstorms, and floods. It reviews the insurance coverage for commercial structures and business personal property in general, and discusses a variety of interacting factors that influence the insuring of commercial structures and their contents. It describes how this insurance is marketed (i.e., by agents, exclusive agents, and brokers) by examining the roles of the major players, including ''risk managers."

Commercial property insurance policies provide indemnification to the policyholder for direct damage to insured structures and business personal property. They can also insure consequential loss such as that caused by the interruption of business. Direct damage to insured structures and business personal property includes payment for the repair or replacement of the damaged property. Business interruption coverage generally provides indemnity for the loss of net income and continuing expenses and helps to assure that the business will survive the repair period.

Most types of property owned by a business are, or can be, covered under a commercial property insurance policy. For instance, the following types of property may be covered:

• building structures

• non-building structures

• business personal property:

  • furniture

  • fixtures

  • equipment

  • supplies

  • machines and machinery

  • stock (raw, in-process, and finished).

To avoid disputes, there should be a clear understanding of what the policy covers and what it excludes. Most commercial property insurance policies exclude:

• foundations and other underground property (i.e., pipes and drains)

• grading, excavations, and filling

• plants, lawns, trees, shrubs, growing crops, and land

• paved surfaces, roads, bridges, piers, wharves

• detached signs, antennas, fences, and other outdoor items

• building glass

• retaining walls not a part of a building

• vehicles licensed for road use, watercraft, and aircraft.

Commercial property insurance policies also exclude any property specifically insured under another policy, as well as property sold by the insured under conditional sales installment plans, or other deferred billing plans after delivery to the customer. Also excluded are money, securities, precious metals, and bullion, as well as fine arts, jewelry, watches, furs, and silverware. Excluded items are often covered by endorsement. Again, the important point is to know what is covered, and what is not.

Additionally, in evaluating the coverages, consideration must be given to limits of liability (amounts of insurance), deductibles, and coinsurance clauses.

Starting with basic definitions, there is confusion at the outset, because although all buildings are structures, not all structures are buildings. Examples of non-building structures include silos, water towers and tanks, swimming pools, oil tanks, wharves and piers, bridges, covered bridges, and enclosed walkways—all of which may be covered under commercial insurance. Adding to the confusion is the fact that architects, engineers, and underwriters do not define or classify structures similarly. This appendix includes a discussion of building classifications and relates them to underwriting and developing premiums for different structures. The appendix also discusses the occupancy and location of buildings.

Insuring commercial structures and their contents involves the need for specialized knowledge regarding the construction of the structures and the equipment, machinery, and furniture they contain. It also involves the development of tailored or manuscript coverages, the use of coinsurance clauses and replacement cost provisions, as well as the adoption of underwriting techniques, tools, or devices that accommodate the peculiarities of these structures and their occupancies. Additionally, the underwriting process must consider the perils to be insured, amounts of insurance (exposure values) to be provided, and types of coverage.

The total value in 1993 of all commercial structures in the continental United States was $11 trillion, which represents an increase of 190 percent from 1980, and a 65 percent increase over 1988. The 1993 value of residential and commercial property in the first tier of coastal counties from Maine to Texas, a band of real estate approximately 50 miles in width, was $3.15 trillion. This represents an increase of 178 percent from 1980, and 69 percent over 1988. As the population of the United States continues to grow, and as more and more people settle in the Sun Belt and recreational areas, the value of residential and commercial structures will likewise grow.

Property valued at $1.507 trillion, or 14 percent of the total value of all commercial property in the United States, is situated in the Atlantic and Gulf Coast counties. These properties sit directly in the path of potential hurricanes, severe windstorms, and the ravages associated with

storm surge and sea level rise. The remaining 86 percent of the 1993 values of commercial structures are generally found in inland metropolitan centers and along the West Coast. Many of these locations are subject to earthquakes, severe windstorms, mud slides, floods, tornadoes, wildfires, and hailstorms. No property is immune to the ravages of Mother Nature.

These figures refer to the value of buildings and other structures and do not include the value of contents—that is, furniture, equipment, stock, merchandise, raw materials for work in process, or finished goods. Once rain, snow, dirt, and dust penetrate a building's roof and exterior walls, significant damage to the contents can follow. Costly building contents, such as computers, electric equipment, and manufacturing machinery, are especially vulnerable to loss caused by exposure to natural hazards. While structural values are significant, they represent only a portion of the values to be insured, and the value of contents will rapidly raise the overall values to be insured. Adding to the financial burdens of commercial insurers are the losses that can occur in connection with business interruption, general liability, workers' compensation, and automobile, glass, burglary, and theft insurance.

Over the years commercial property insurance has been widely available, with the exception of insurance against losses related to asbestosis and environmental clean-up, that is, losses associated with the Superfund program. Competition for commercial business has been keen, and regulatory intervention has been practically nonexistent compared to that for the personal lines (homeowners' and private passenger automobile insurance). Will these situations change? Will the commercial property insurance markets be adversely affected by the following issues:

• The failure of steel frame buildings as evidenced in the Northridge earthquake?

• The vulnerability of structures with External Insulation and Finish System (EIFS) siding to wind and rain during hurricanes?

• The apparent increase in frequency and severity of natural disasters (i.e., hurricanes, tornadoes, floods, and wildfires)?

• A potential for greater rates of precipitation (rain and snow) caused, perhaps, by climate change?

Can mitigation programs and techniques and new loss reduction technologies have a salutary impact on commercial insurance? Can new financial alternatives such as Chicago Board of Trade Futures, Act of God bonds, and state catastrophe pools assist in pricing of insurance

policies by providing the required financial cushion against large losses? If not, how can the solvency of insurers be preserved and availability problems avoided?

The underwriting of a commercial building involves a meticulous analysis of its construction, physical characteristics, condition, occupancy, and location. In each instance, the inquiry must be thorough if the loss exposure is to be understood and a proper premium established. As discussed in Chapter 2, not all situations are insurable. In deciding questions of insurability, the actuary and underwriter must make both statistical and administrative (business) judgments. Reasonable exceptions may be made if the insurer has imposed practical controls through underwriting, policy provisions, and other means to compensate for what might otherwise be uninsurable.

In the insuring of commercial property, special attention must be paid to the conditions of insurability because of high values, the potential for more frequent and severe events, and the shrinking of the supply of affordable reinsurance.

Commercial buildings include the following categories of structures: high-rise, reinforced concrete, heavy steel, reinforced masonry, light steel, timber, and unreinforced masonry.

There is no uniform definition for commercial structures that may be used by the various stakeholders. For insurance underwriting and rating purposes the following definitions set forth in the Insurance Service Office's Commercial Lines Manual (ISO-CLM) are used:

• Frame: Exterior walls of wood, combined with brick veneer, stone veneer, wood iron-clad, stucco on wood.

• Joisted Masonry: Exterior walls of masonry material (adobe, brick, concrete, gypsum block, hollow concrete block, stone, tile, or similar materials) with combustible floor and roof.

• Noncombustible: Exterior walls, floors, and roof constructed of metal, asbestos, gypsum, or other noncombustible materials.

• Masonry Noncombustible: Same as joisted masonry except that the floors and roof are of metal or other noncombustible materials.

• Modified Fire Resistive: Exterior walls, floors, and roof of constructed masonry or fire-resistive material with a fire resistance rating of at least one hour, but less than two hours.

• Fire Resistive: Exterior walls, floors, and roof of masonry or fire-resistive material with a fire resistance rating of at least two hours.

These classifications reflect the emphasis placed on insuring loss caused by fire. They do not address the quality of construction or consider the applicable building codes. Under the circumstances, underwriters must probe other avenues of inquiry to ascertain that engineered structures have met at least the standards prescribed by the local building, fire, and electric codes.

The ISO-CLM provides three classifications for wind and seven for earthquake. The wind categories are as follows:

1. Wind Resistive: Modified fire resistive and fire resistive;

2. Semi-Wind Resistive: Masonry noncombustible; and

3. Ordinary: Frame, joisted masonry, and noncombustible.

These classifications give little or no indication of a structure's ability to withstand the forces of wind. They provide no information about the structure's ability to resist the vertical or lateral wind loads or about the building codes under which the structure was erected.

The seven earthquake building classifications identified in the ISO-CLM are:

1. Wood Frame

2. All Metal

3. Steel Frame

4. Reinforced Concrete, Combined Reinforced Concrete, or Structural Steel

5. Concrete Brick or Block

6. Earthquake Resistive

7. Special Structures.

Each class and its applicable subclasses are described in the ISO-CLM. The adequacy of these classifications for identifying the earthquake vulnerabilities of buildings is questionable. It would seem that to reduce the uncertainties, these classifications should be related to information on soil conditions and distance to the fault line. Has the time arrived when a new set of fire, wind, and earthquake building classifications is needed? Should these new classifications be constructed so that they are compatible with some type of model code, such as the Uniform Building Code discussed in Chapter 7?

The ISO-CLM classifications are used to distinguish between those buildings that can be class rated or specifically rated. Class-rated buildings are those structures that can readily be grouped together because of:

• similarity in size (15,000 square feet or less),

• construction (i.e., classified as frame, joisted masonry, and noncombustible),

• occupancy (i.e., the use to which the premises is being put: apartment units, offices, mercantile purposes, mercantile and apartments or offices, manufacturing, etc.).

Specific rates are reserved for large, high-rise buildings (i.e., above six stories), and buildings with sprinkler systems. Buildings classified as masonry noncombustible, modified fire resistive, and fire resistive must be specifically rated. The specific rate is developed after a detailed inspection of the building. In an effort to contain underwriting costs and make policies more affordable, insurers are moving away from specifically rating commercial buildings, and are making greater use of class rates.

The occupancy of a building determines not only the rate to be charged the individual or firm using or leasing the premises, but also affects the rate applying to the building. For instance, an apartment or office building presents less potential for loss than a building that houses a restaurant, auto repair shop, solvent, or explosives manufacturer.

Because most commercial buildings are not owner-occupied, and since the lessees change from time to time, the underwriter must obtain current occupancy information to evaluate loss potential, and properly rate both building and contents. The type of occupancy will determine whether a building and its contents are eligible for class rates or must be specifically rated. An apartment building is always eligible for class rates, but a mercantile-apartment building with a restaurant on the first floor must be specifically rated. Restaurants, or the buildings housing them, are never eligible for class rates.

Commercial property insurance policies generally provide that an increase of hazard—i.e., a physical change in risk—will suspend or restrict the insurance policy. Thus, the property owner or occupant has an obligation to notify the insurer of changes in any hazard associated with the occupancy.

An important factor in establishing the class or specific rate for a property (building and contents) is its location. In large measure, both class and specific rates are predicated upon a community's fire exposure and experience. Cities and towns are graded for the quality of their fire protection and the availability of their water supply. The Public Protection Classification Manual, developed and published by Insurance Services Offices' Commercial Risk Services, Inc., contains the grading specifics. A grade of 1 means that a community has the best available protection; a grade of 10 means that it has no protection. In classes 9 and 10, listed as "unprotected," the grade is determined by the distance to the closest fire hydrant or fire department; these two classes are generally found in rural areas.

In addition to fire exposure and protection, location is also a factor influencing loss caused by the natural hazards such as hurricanes, tornadoes, severe windstorms, floods, and earthquakes. Over the years, property insurance underwriters have tended not to give significant attention to the location of a risk, since they viewed fire as the predominant cause of loss. With the movement of more and more people into the coastal plains, to the shorelines of the Great Lakes, to the edges of major tributaries, to recreational areas, and to the West Coast, where wildfires and earthquakes pose a threat, a new awareness of natural hazards is emerging among underwriters.

Commercial property insurance underwriters are becoming more knowledgeable about location, and the need for land use planning. Underwriters are not only assessing the physical attributes of structures, but are also weighing the characteristics of the land and the amenities of the location, both of which influence and affect the loss potential.

Little information has been published in the past about the effects of natural hazard perils on commercial structures. Researchers and policy-makers are experiencing a growing need for data on claims payments in particular. This information is necessary to identify issues and establish programs for effective, efficient, and economical hazard mitigation. In the past, several factors have worked against the collection and aggregation of loss payment data—namely, competition, antitrust concerns, and privacy laws.

Insurers have not wished to divulge any information to competitors about their insureds. Information on specific risks was deemed proprietary, and was not released for use by others. Another factor inhibiting data collection involves the industry's statistical plans, whose data fields are becoming increasingly complex. The industry has staunchly resisted efforts to expand the statistical plans to accommodate new and desirable information—for instance, a more detailed breakdown of the "cause of loss" codes to distinguish losses caused by hailstorms, tornadoes, hurricane, and other instances of severe winds, rather than designating all of these situations as "wind." The creation of new wind and construction classifications is considered not necessary and extremely costly from an operational standpoint. Use of the statistical plans, it has been argued, should be confined to the acquisition of data elements used in the current rate-making process. This argument does not consider the advent of powerful personal computers and more sophisticated software packages, and the ability to collect and compile data that previously had been beyond reach.

Damage to commercial structures caused by natural hazards can affect society as severely as natural hazard damage to residential buildings. In this regard, the small business area particularly requires attention. The paper by Daniel J. Alesch and James N. Holly (1996) provides the following insights:

The report goes on to cite the following community impacts which, in turn, provide additional reasons for the need for a comprehensive research program.

Finally, the report emphasizes social costs.

The importance of small businesses in the economic scheme of the United States is difficult to overstate and should not be overlooked. In an era of downsizing, small businesses have provided a cushion, absorbing in their employment ranks many thousands of the individuals cut adrift. Alesch and Holly chronicle the plight of small businesses in the face of extreme natural hazard events, based on the effects of the Northridge earthquake. Further research is needed to determine the extent to which their findings apply to the impact of other types of natural disasters, such as floods, hurricanes, and other types of earthquakes. The authors, however, delineate crucial issues that commercial insurers grapple with as they try to provide products that are available and affordable while protecting the solvency of their companies.