The insurance sum – the amount which the insurer is obliged to pay out in the event of a successful claim – is a fundamental element of any insurance agreement. What does it depend on and how is it calculated? Russian legislation does define a base amount; however, the final decision rests with the policyholder and the insurer.

Property Insurance

In accordance with Russian legislation, the insured amount is defined as the actual value of the property at its location on the day the insurance agreement was concluded. However, neither the Civil Code nor any insurance legislation defines what “actual value” is. This means that the insurer and insured party have to mutually decide on this standard based on one of the several different valuation principles at their disposal.

Replacement Value

A basis for the calculation of the insurance amount can in many cases be provided by the replacement value. “At the moment the agreement is concluded the sides define a certain sum, taking into account depreciation and the condition of the property, required for the complete replacement of the damaged property,” says Mikhail Alekseev, head of property insurance and liability at Capital Insurance. “Replacement value can be confirmed by documents provided by the insured party, for example, construction estimates that reflect the owner’s expenditure for the construction of a building. Also the sides can use the services of a professional valuer. In this case, the correct amount is that provided in the valuer’s report as the comparable value defined by a cost plus evaluation method.

“If a real estate property is an important revenuegenerating asset we always recommend that it be insured at its replacement value,” says Lola Rakhimi, head of industrial insurance management at Renaissance Insurance. “It is important that the owner receive an insurance amount that would allow him to replace the damaged part of the building or the entire property should it be completely destroyed. This calculation should include the cost of construction materials, their delivery and current labor costs.”

Sergei Tishakov, head of property valuation at Rossiiskaya Otsenka draws our attention to the following nuance: “It’s important to note that since the aim of the insurance is the receipt of fair compensation from the insurer for damages incurred, the determination of the base value should take into account all expenditure including replacement value and possibly company income as understood by the valuer in the corresponding costs model.”

Balance Value

Often the basis for establishing the insurance amount is the balance value of the property. This method differs in that that the balance value of an asset does not relate to the actual construction costs of a building. So, the insurance payout will equal the value of the damaged property as reflected in the balance documentation and most likely be insufficient to fully compensate for the damages incurred.

It should be noted that under this scheme the insured party is usually attracted by the low cost of the insurance policy. However, does it make sense to pay for a policy if the owner will only receive a nominal amount? “This method is used to insurance the property of many companies; however, it doesn’t meet the requirements of clients or a professional approach from the insurer,” believes Mikhail Ilin, director of investment projects at NEO Center. “If the insurance amount is based on the balance amount then in the event of serious property damage the insured party will receive compensation not in the amount of the real losses incurred but on the basis of the balance value, which is frequently understated. So, an apparent saving on the cost of the insurance easily translates into losses on the part of the policy holder in the event of a claim.”

Frequently, this method of property valuation is used when an insurance agreement is simply a necessary formality. “In general, balance value is used as the basis for the insurance amount for insurance policies for state enterprises, which civil servants are required to insure often during their transfer to lease property for commercial use. Entrepreneurs who are the owners of expensive property tend to insurance it at the actual replacement value,” added Ms. Rakhimi.

Market Value

Can market value be used as a basis for the insurance value? Specialists regard this is a deeply controversial issue. “This is not forbidden by law, but market value cannot be regarded as a sufficient means for valuing a property,” said Mr. Alekseev. “The market value of an asset changes according to a large number of subjective factors including: the current market situation for similar properties, the cost of the land beneath the property, location and distance from developed infrastructure, etc. In addition, the market value, by its very nature, implies that the owner should receive a specific amount of profit from the sale of a property and insurance should not serve as a source of profit.” Mr. Tishakov provided a similar view: “When it comes to real estate insurance, the balance value of a property generally doesn’t adequately reflect its value and its market value also incorporates the cost of the land, which can’t be included in an insurance compensation package. Consequently, the most widely used basis for establishing the insurance sum is the replacement value.”

Partial Property Insurance

There exists yet another subtlety relating to establishing an insurance sum, and this time it is clearly defined in Russian legislation. The insurance sum cannot exceed the actual value of the real estate property. If this occurs, then the amount in excess of the actual value is considered invalid. On the other hand, if an owner insures a building for less than its actual value, i.e., just a part of it, then the insurance payment is calculated according to the ratio between the insurance sum in the policy and the actual (complete) value of the damaged property (proportional insurance).

It should be noted that proportional insurance schemes are suitable if the sides have not included a firstloss insurance scheme (described in detail, below).

Independent Valuers

The decision to engage a professional valuer is taken by the insured party and the insurance company. It should be noted that there are no legal requirements to use an independent valuer to establish an insurance sum or payment. “Of course the services of independent valuers are used, but not very often,” says Mr. Ilin. “Currently, property valuation for insurance purposals is not a large segment for us, because the market has not developed to the extent that one would hope. Both sides typically want to avoid additional expenditure, especially taking into account that the cost of valuing a large property complex is substantial.”

“Generally, professional valuers are used to establish rights to compensation, put simply, the insurance payment amount” says Mr. Tishakov. “Since the amount of compensation is defined as the difference between the value of the property before and after the insured event; it is strongly advisable to use an independent valuer to report on the condition of the property and define its replacement cost – taking into account any depreciation. Moreover, in order to define the condition of a property after an insured event other specialists are also required, for example, construction companies with licenses to carry out engineering surveys. Following this, the independent valuer, acting on the basis of the specialist findings, can reach a proper conclusion about the financial value of the insurance payment.”

Liability Limits (First Loss Insurance)

The Western concept of first loss insurance is gradually making the transition to the Russian market.. First loss insurance is insurance with an established liability limit regarding the maximum liability on the part of the insurer, i.e., a limit on the maximum amount payable in the event of a claim.

Specialists comment that insuring a real estate property at its full value is not always economically advisable, for example, in the case of very large assets whose total loss is extremely unlikely. In this case a payment liability limit is set for the insurer. “In insurance terms, a liability limit represents a flexible way of insuring concrete risks, which enables insured parties to considerably lower their insurance costs without risking the complete loss of their property,” explains Mr. Ilin

A similar method is used in Russia, albeit with a local “twist” as explains Mr. Alekseev. “In practice, in Russia, liability limit insurance is used unjustifiably as a means for companies to avoid insuring properties at their full value, therefore making it impossible for insurers to use a proportional insurance approach in the event of losses. In our view applying a Western approach in this context is fundamentally incorrect. First loss insurance is only suitable when the total loss is in reality impossible for objective reasons, which should be accompanied by a calculations of the “maximum anticipated loss” and “maximum potential loss.”

Civil Liability Insurance

The current understanding of “liability limit” also includes a civil liability risk to third parties. One of the specifics of this type of insurance coverage is that accurately estimating losses, for example incurred by a management company from a third party, e.g., tenants is impossible. Consequently, the liability of the insurance company is limited by a hypothetical sum based on the market practice for liability insurance. “In personal and civil liability insurance agreements the insurance sum is defined by the parties at their discretion,” states Article 947 of the Civil Code of the Russian Federation.

Here the task facing the insurer is evaluating the level of risk associated with the type of business, how well qualified the company’s staff are and what type of experience the company possesses, for example in the management and renting out of commercial premises or the operation of warehouse terminals as well as the total area of premises covered by the company’s activities and the levels of possible damages that could arise as a result of these various risk factors. Depending on all these factors a civil liability limit is established with the main criteria being the maximum possible insurance payment according to the established liability limit covering possible damages to third parties.

Here is a simple example, an insured party accidentally floods a neighboring office located on the lower floor of the same building. You can forecast with a high degree of certainty that the amount of damages sought by say the branch of a bank and a recruitment agency will be different. A financial organization will most likely make a claim based on lost revenue and the cost of replacing expensive equipment, etc. An insurance company has to recommend, based on its market experience a liability limit that corresponds to the professional activities of the company’s neighbors.

Interruption of Commercial Activities

In this case, the insurance sum relates to the potential losses that could be incurred by the insured party in the event of an interruption of commercial activities. “This kind of insurance includes: ongoing expenditure costs incurred by the owner regardless of the onset of the insured event such as taxes, loan repayments, communal charges, wages and social deductions as well as lost profits,” explains Ms. Rakhimi.

As far as lost profits are concerned, it is clearly understood that lease payments provide profits to the owners of commercial real estate and so the task facing the insurer is to guarantee this revenue in the event of a event that could be qualified as insurable. In terms of the calculation of the sum of the insurance payment, the Civil Code includes such factors as the average profit levels, the commercial turnover of the insured party and the potential length of the interruption in its commercial activities. It should be borne in mind that the process for establishing losses due to interrupted commercial activities is labor intensive and includes the analysis of a large number of financial documents, contracts, additional agreements, supplier agreements and invoices, etc.

And how does all this look from the point of view of an independent valuer? “Identifying losses as the result of an interruption in commercial activities (lost profits) is generally based on the income that the valuer regards as a shortfall in revenue streams from the ownership of the damaged property and future shortfalls in revenue streams at the current value using a discontinued revenue stream method,” explains Mr. Tishakov.

Conclusion

As we have already mentioned, the level of insurance payment is dependent on the wishes and requirements of clients. “The task facing the insurance market leaders is to create for clients optimal, effective insurance systems to protect their property interests. And since, in parallel with the current legislation, there exists a range of different approaches towards property valuation, it is vital that companies reach an agreement beforehand concerning all the myriad elements of an insurance agreement,” concludes Mr. Alekseev.