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Budgeting Insurance Costs: Rocket Science Or Guess Work?
For the majority of associations, September and October are budget season. This can be a stressful time, particularly if the association has run over budget or the board has already pre-determined that the net result should be no increase in monthly assessments to unit owners for the upcoming year. In reality, this is a time for a reflection on the financial health of the association and an opportunity to right the ship if the prior budget had been unrealistic, had been impacted by unexpected expenses, or is unsustainable based on the reserve study or other considerations.
As a manager or board of directors peruses each line item that makes up the budget, rest assured the cost for insurance will be right up there as one of the largest expenses. This applies only if you are a condominium or an association required by your documents to insure the real property (a few homeowner associations with townhouses are required to insure their property as if it were a condominium). In some cases, where the association purchases earthquake insurance, this line item may actually be the association’s largest expense. This big number draws extra scrutiny and unfortunately is sometimes given the hatchet treatment or given less than a dose of reality. So what might be the considerations when establishing estimated insurance premiums to be used for the upcoming year?
Let’s start with the basics
As a board member or a manager do not just plug in a number for the upcoming insurance premiums in a vacuum, be it the same as expiring or a percentage increase. Your insurance agent should be consulted. Their crystal ball is likely to be less foggy than yours as they would be familiar with the changes in rates or premiums that they’re seeing from the current insurance company(ies) as well as trends and appetite in the market if other companies are being asked to provide a proposal. However there are many other considerations aside from market trends that can have an impact on the premiums for the coming year. Let’s look at some of these:
Increased Property Replacement Cost Value.
You would be remiss in using the same replacement cost values for your buildings or property as per your current insurance policy. These costs are trending up right now. Changes in property values are sometimes automatic and triggered by an inflation guard endorsement built in to your policy. This typically would range anywhere from 2 – 8% depending on the insurance company. Remember, almost universally, you are required to insure the property to 100% of replacement cost so it is in your best interest to know what these numbers should be. Having an Agreed Amount policy, Extended Value, or Guaranteed Replacement Cost endorsement does not negate the responsibility although it is helpful. If unsure, you have nothing to lose and everything to gain by having a third party insurance replacement cost appraisal done which should include all of the property to be insured (some reports I read exclude the costs of property intended to be insured). The bottom line: if the property replacement cost value is increased by 4% then the premium is likely to be going up 4% assuming that the property insurance rate is as expiring. A 4% increase in property replacement cost value and an estimated increase in insurance rate of 4% will result in an increase in property premium of over 8%.
Yes, this does factor into the potential for a change in premium. This is more so if there has been a frequency of events rather than one large loss. In cases where the recent loss record has been exemplary and a frequency of losses that occurred more than three years ago is now dropping off the radar, a good case can be made for reducing premiums, gaining a lesser increase, or potentially getting alternative proposals from an insurance company that might otherwise have declined the risk. Also, if your association buys high risk insurance such as Earthquake or Flood coverage you are unfortunately going to be impacted by events outside of your control such as a hurricane that causes billions in damage or a new unfavorable earthquake modeling study of the Puget Sound area, the results of which are adopted by many insurance companies.
Reserves and/or monthly assessments.
Changes in these numbers will have an impact on the limit of insurance required for Crime insurance based on the mortgagees requirements. While likely a small premium adjustment in the big picture, there are times when increase in limit may result in an increased deductible too. Does your association budget for a Crime deductible let alone Property, Earthquake, or Directors & Officers coverage where deductibles can be substantial?
What else can impact insurance costs?
What has the association done this past year in terms of proactive maintenance (examples: new roof, all hot water tanks replaced); risk management (examples: seismic gas shut-off valve installed, barbecues banned from decks, railings with 6 inch gaps have been replaced and brought up to code); or generally done to make the risk more desirable by either mitigating, transferring, assuming, eliminating or financing risk? Every insurance company has its unique appetite for risk and bandwidth of credits and debits they can use. Your agent should be the messenger of changes that can help your association gain the ‘best of class’ rates and premiums.
To summarize, it is important that due diligence is used in establishing the estimated premiums to be used for the proposed budget. Your insurance agent should definitely be a party to such discussions as one of your trusted advisors. If there is concern about a turbulent history of significant unbudgeted insurance premium changes, there’s a simple solution. Your annual policy period can run from whatever date you choose. Why not have the association’s insurance renew around the time of your budgeting process so that you can use real numbers and, if necessary, spread the cost over two budget periods? Many of our firms’ community association clients have elected to do this and are all the better for it.
Here’s to a successful and smooth budgeting season!