Are You Under (or Over) Insured? Analyzing Replacement Cost for Hospital Systems, Investors & other Healthcare Providers

June 4, 2021

Evaluating the replacement cost of the facilities and equipment for your hospital system should involve a formalized, detailed process, whether occurring at regular intervals or on an as-needed basis due to specific events (property damage due to natural or man-made causes, acquisitions, new construction or renovation).

There are risks to being over insured or under insured. The primary risk of being over insured relates to increased operating costs which occur through higher premiums, higher deductibles, or both.  If property insurance is being passed through to tenants in a triple-net lease structure, it could also create leasing challenges due to higher operating expenses.  Or, if the leases are on a “gross” basis, the higher operating expenses can diminish the building’s profitability.

Being under insured can create significant financial exposure.  For instance, a casualty event could result in large, unexpected out-of-pocket costs which could limit the ability of a hospital system to pursue other strategic initiatives.  For a hospital system operating on thinner margins, this occurrence could be financially catastrophic.

The specialty nature of most healthcare properties and the associated construction costs require specific expertise and data.  Some insurers, consultants, or valuation professionals may not be aware of the incremental buildout costs associated with higher cost building components such as imaging, operating rooms, radiation treatment vaults, and so forth. Furthermore, some property types and specialty features have seen cost increases which are higher than the overall average for general commercial buildings or office buildings. The replacement cost for surgical centers, cancer centers, imaging centers, acute-care hospitals, critical-access hospitals, and commercial laboratories must be tested against the proper market cost data by professionals with the appropriate specialized experience to ensure that risks are properly mitigated. A similar approach involving current market cost benchmarking should be used to evaluate the replacement cost of tangible personal property and other expensive and sophisticated equipment within these facilities (robotic surgical/navigational systems, MRI, CT Scan, radiation therapy systems, and laboratory testing/analyzer equipment).

The beginning of any meaningful replacement cost analysis should start in determining the appropriate replacement cost definition and parameters which are most applicable to a hospital’s insurance policy. There are several definitions available for replacement cost and total insurable value (TIV) within the marketplace, and the specific insurance policy definition may have variances that should be considered. Definitions of total insurable value may or may not include all components of owned property, and a particular policy may protect an amount less than the replacement cost or total insurable value for the purpose of lower premiums or deductibles.  A few pertinent definitions from industry sources include the following:

  • The Dictionary of Real Estate Appraisal, 6th Edition defines replacement cost as “The estimated cost to construct, at current prices as of a specific date, a substitute for a building or other improvements, using modern materials and current standards, design, and layout.”
  • The American Society of Appraisers define replacement cost new as “The current cost of a similar new property having the nearest equivalent utility to the property being appraised, as of a specific date.”
  • The International Risk Management Institute, Inc. defines total insurable value (TIV) as “A property insurance term referring to the sum of the full value of the insured’s covered property, business income values, and any other covered property interests.”
  • Marshall Valuation Service (MVS) MVS defines replacement cost as “The total cost of construction required to replace the subject building with a substitute of like or equal utility using current standards of materials and design. These costs include labor, materials, supervision, contractors’ profit and overhead, architects’ plans and specifications, sales taxes and insurance.”

After evaluating the nuances within the definition applicable to a particular hospital’s policy, a professional can account for potential non-perishable items or other components not covered. This could include building foundations, site improvements, certain categories of profit, or other equipment-specific soft costs such as installation, calibration, and testing. The investigative process itself could expose omissions in the policy that need to be re-evaluated. Another consideration when evaluating the appropriate premise of value is that fair market value is likely not a reliable proxy for insurable replacement cost. Fair market value includes depreciation and obsolescence related to loss in value due to physical wear and tear, functional inefficiencies, and/or economic and other external factors. Similarly, book value, either gross book value or net book value disclosed in a hospital’s financial statements, should not be utilized for insurance purposes. Book value is generally based on capitalized cost, as of a specific acquisition date, and does not reflect changes in cost since installation.

In addition to our experience evaluating replacement cost for healthcare buildings, VMG Health has extensive experience providing medical equipment replacement cost analysis and physical inventory services for hospital systems and other healthcare entities. Some of VMG’s recent experience in this sector is summarized below.

  • Equipment: Recent and relevant work related to medical equipment replacement cost analysis includes the following:
    • 25 acquisitions for a 13-hospital southeastern non-profit health system.
    • Fixed asset management for a 2-campus hospital in Florida.
    • Physical inventory/equipment valuation for a 2 million square-foot medical and research center in the Middle East.
  • Real Estate: Recent experience with real estate replacement cost analysis includes:
    • RCN For Health System Insurance Policy Analysis – Recently completed comprehensive replacement cost analysis for a non-profit health system related to owned properties. This involved property-by-property analysis of ~5 million square feet of real estate assets across a wide array of property types.  VMG conducted a site visit sampling and provided a comparison of values versus previous insurable values.  VMG also constructed an automated model that the health system could leverage on future updates (or changes to) its replacement cost analysis.
    • RCN to Assist With Investment Risk Analysis – VMG assisted an institutional real estate investor with analyzing replacement cost in more than a half-dozen different metropolitan areas as part of its underwriting process. The purpose of VMG’s analysis was to assist the investor in analyzing rental rates for new construction within each market relative to the in-place rental rates within an existing portfolio of medical office buildings and other outpatient assets.
    • RCN for Surgery Center Platform Company – VMG assisted a surgery center platform company with analyzing replacement cost in various markets to assess the likelihood of competing surgery centers opening up in the given market.

If you are evaluating whether you are under- or over-insured, or otherwise require a replacement cost analysis pertaining to real or personal property, please contact VMG Health.  As the market leader in healthcare valuation and advisory, VMG is well-equipped to provide reliable guidance to health systems evaluating this issue.

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