Amid the overwhelming and heartbreaking stories of the recent devastating Los Angeles wildfires, there is a passage in a Wall Street Journal article that should stand as a cautionary tale for anyone running their own business:
“The restaurant has more than $1 million in insurance, which includes coverage for business interruption and rebuilding. But the actual costs of rebuilding are likely to be far larger.”
The restaurant in question is a family-run fish shack known as the Reel Inn. For almost four decades, this Malibu restaurant was a popular spot known for its fresh seafood and playful charm, including pun-filled menu items such as “Salmon and Delilah” and “Leprawn James.” It drew a diverse crowd, from surfers, to tourists, to celebrities. By all accounts, it was a cherished part of the local cultural fabric.
This beloved restaurant met a devastating end when fire tore though and reduced the place to ashes. Compounding the tragedy, it would appear the business might have been underinsured.
Although this tragedy unfolded in California, the risks it highlights are no less real for Canadian business owners. The story raises an uncomfortable question: How many small businesses in Canada might be similarly vulnerable? Whether it’s a cozy bookstore, bustling flower shop or independent café, a small business helps form the backbone of a community. Yet, the owners of many of these businesses may unknowingly be underinsured, leaving them exposed to financial devastation in the wake of a disaster.
There are steps that business owners can and should take to ensure they are adequately protected.
The Double Threat: Rising Risks and Soaring Costs
Building and business owners today face a double threat in safeguarding their assets: (1) the escalating frequency and severity of natural catastrophes, and (2) rising rebuilding costs.
In the past 15 years, severe weather events have caused financial losses for over 132,000 businesses in Canada, with an upward trend over time, according to data from Catastrophe Indices and Quantification Inc. (CatIQ). In the past five years, more than 53,000 businesses initiated claims resulting from severe weather, compared to about 40,000 in each of the two preceding five-year periods. Insured losses across all lines, including commercial, have jumped from $10 billion to $12 billion to a staggering $20 billion over the same 5-year timeframes.
Meanwhile, the cost of rebuilding has never been higher. Canada’s Consumer Price Index (CPI) of October 2024 found construction costs in Canada had risen by 66% since 2019, significantly outpacing the 19% general inflation rate over the same period. For businesses, this increases the potential for outdated insurance valuations that are dangerously out of sync with the current market cost of rebuilding.
How Co-insurance Works
Many business owners may be unaware of how underinsurance can amplify financial losses after a disaster. Most commercial property policies include a co-insurance clause, which exists to incentivize accurate valuations, and means that the business owner may have to pay a portion of a loss. More specifically, it says that the insured value must meet at least 80% to 90% of the property’s replacement cost. Falling below this threshold means that the policyholder effectively becomes a co-insurer, responsible for covering a proportional share of any loss, whether total or partial.
For example, if a building’s replacement cost is $2 million, but the owner insured it for only $1 million, the owner covered just 50% of its value. If the building suffers $500,000 in damages, the insurer will pay only half of that amount ($250,000). The owner must cover the rest out of pocket – a staggering financial burden that could close a small business for good.
This co-insurance clause applies not only to physical property but also to business interruption coverage, which compensates for lost income during the rebuilding period. Policyholders must insure their revenues to an appropriate value. If coverage limits selected are too low, the business may struggle to recover financially even if it reopens.
The Solution: Accurate and Up-to-Date Valuations
To avoid being underinsured, owners should have an accurate replacement cost (RC) appraisal, based on all of the required variables (material and labour costs, debris removal expenses, building bylaws, costs related to heritage buildings and others). An appraiser can look at the building and develop an RC appraisal based on today’s cost to rebuild. This snapshot-in-time appraisal can be used to keep building insurance values in line with the true cost to rebuild.
The building owner may use the base appraisal for the next three years in conjunction with the current year's Building Construction Price Index from Statistics Canada, to approximate the cost to rebuild when they renew their insurance policy.
Business owners must also monitor the value of their stock and equipment and ensure that in case of a major loss, the coverage limits are adequate to replace them. Commercial customers should speak to their insurance representative annually to ensure their coverage continues to meet their needs.
It is critical to get insurance valuations right. While no one can predict when disaster will strike, businesses can take proactive steps to safeguard their future and be fully protected when it matters most.
