Following the tragic events of September 11th, as we are all aware there have been dramatic changes within the world-wide insurance market. Without doubt, many of these changes were in the wings well before "911", the incident in many cases giving the impetus to move away from the soft underwriting market experienced up to that time.

Amongst many of the topics that underwriters are currently grappling with, are the values at risk presented to them, particularly in the areas of oil, gas, petrochemicals, power generation, hot metals, etc., where the sums insured are measured in hundreds of millions or billions of US dollars.

Bearing in mind the reductions in capacity both onshore and offshore in the last six months, leading to some Insureds having difficulty getting 100% of their portfolio placed in the conventional/direct market, accurate sums insured are imperative.

Whilst most organisations keep records of capital expenditure on buildings, plant etc., those records are often incomplete and are principally used for depreciation in respect of taxation allowances. Whilst these records do perform a specific purpose relative to taxation, they are of very little use for any other purpose associated with asset management or insurance.

When an organisation has a need for accurate values, the initial thought is often to turn to those "internal" records and arrange for someone within the finance, property, or engineering departments, to produce the appropriate appraisal using the records that are available. As will be appreciated, this can prove extremely difficult and time consuming for a number of reasons. Principally, the individual involved would have no real appreciation of the needs and circumstances leading up to the appraisal and of course, they already have their own job functions to fulfil. It is appropriate, therefore, in these circumstances that the organisation approach professionals to undertake the task for them.

Although this may initially be viewed as an expensive option, should the need arise to fall back on the appraisal at a later stage, when an insurance claim occurs, it will then be viewed as money well spent. Currently, if the present value at risk is over inflated for whatever reason, it not only exacerbates the problem of placing the risk 100%, but also with the increased premium rates it costs the insured dearly in premium terms. Conversely, if the value at risk is insufficient, not only is there a claims settlement problem, but more than one energy underwriter has avowed that if they believe/suspect that the sums insured are inadequate the rate ‰ will be further loaded, in addition to the significant increases that are already being applied.

To provide meaningful sums insured to an organisation's brokers, underwriters, captive, etc., accurate replacement values of buildings, plant and machinery are required, i.e.

The cost of replacing the assets in new condition, but like design, as the existing assets when new, whether they are buildings, plant or machinery.

Many countries are now expanding into the world commercial market and it is essential that in the insurance context the insured fully understands, what "current replacement value" means. The provision of the correct sum insured is essential in order to ensure that the insured is adequately protected in the event of an insured loss and that the underwriters receive adequate premium for the risk they are taking. In other words, value at risk = sum insured.

Appraisers whose job it is to assess value, will as part of their studies, take into account not only the general capacity and type of the facility under review, but also its particular location, prevailing weather conditions likely in any reconstruction period, etc. They will also review the design, specification, materials, standards of construction, country (and hence market) of origin for all main equipment, construction techniques, labour, etc., plus what would be the most likely scenario for all of these in the local circumstances that currently prevail.

The question of under insurance has already been mentioned, over the years of the soft underwriting market, the condition of average, (or full value clause), tended to be removed from policy wordings. However, with the tightening of underwriting principles, the reintroduction of average is a real possibility.

In the insurance market at the present time, the most common average clause is "day one average" which requires the sum insured to be correct on the first day of the policy period and then there is an automatic escalation for the policy period built into the wording. As a matter of general practice, insurers are not unduly concerned in respect of minor amounts of under insurance, though the higher the discrepancy the more the insurers will insist on a deduction from the claim settlement, therefore the more money the insured has to find in order to complete the repairs or reinstatement following a loss.

In real terms, the application of average is a simple mathematical formula, for every one percent of under insurance; one percent is deducted from the settlement of the claim.

In simple terms, replacement as new, is the replacement cost of an item, or facility, equal to, but no better or more extensive than when new. Subject to the particular item or facility, it should include all costs associated with replacing the items usually including:

• The "ex works" purchase costs.
• All freight transport and insurance to site costs.
• Import and customs duties if applicable.
• The installation and erection costs including all materials, equipment and labour.
• Connection to services, electricity, air, gas, water, etc.
• Contractors' overhead, profits, fees, including mobilisation, demobilisation, crane and machinery hire, etc.
• Any other relevant costs, foundations, structures, access ways, etc.

In any Appraisal, any problems of obsolescence at the facility must be considered, which can be due to several reasons including:

1. Technological obsolescence, process, metallurgical, energy efficiency, etc.
2. Capacity.
3. Changes in the commercial market, e.g. from Central Planned to Free Market Economy, etc.
4. Environmental and legislative changes.

All of these can have a bearing on the Value at Risk and consequently the sums insured.

On an ongoing basis, one of the things that must be constantly monitored, are exchange rates. Since most large facilities have equipment emanating from around the world, it is essential that relevant currencies are tracked in order to provide accurate values for reconstruction, not only at the time of the initial appraisal but on an ongoing basis. To give some idea of the changes which have taken place in respect of four major currencies against the US$ over the last ten years, the divergence is more than 200% between the highest and the lowest.

There are a number of published indices, which are used by Insured's to update their values. Unfortunately, though they give an indication of possible "error" on existing values at risk, they are notoriously inaccurate. In the first instance the data on which the tables are based is usually 12 to 18 months old before publication, secondly, the indices are industry and region specific. For instance the Nelson Index is based on petrochemical facilities located on the West Coast of the USA, as has been said, their use can help identify a problem, but cannot normally solve it.

In any situation particularly in areas of high economic growth and also high inflation, appraisals very quickly become out of date. As a general principle whenever proposals are prepared for clients giving scopes of work and fees they also incorporate details of appraisal maintenance. The principle being that annually, usually to suit renewal negotiations, a review is undertaken of the appraisal taking into account changing prices of building materials and equipment, currency fluctuations, additional facilities brought on stream and facilities which have been taken out of production, disposed of, etc.

The exercise is undertaken in the appraisers offices without a site visit, the Client providing details of any significant changes to their facilities during the preceding year or since the last site survey.

As a closing statement, it will be realised that the final destination of the figures, in any insurance appraisal report, will be the Insurer. If the Valuers have the opportunity to discuss the underwriting and the calculation of maximum probable loss (MPL), before going on site, they can, at no extra cost, provide specific information, regarding values, in the areas or circles which are used to calculate the MPL's. In addition information such as susceptibility to damage of surrounding property etc. can be provided. This can often be very beneficial in allowing Underwriters to see a more positive view of a risk and calculate premiums accordingly.

Tony J Prior MIRM MInstPet

March 2002