The Cost of Underinsurance in the Canadian Commercial Real Estate Market

Underinsurance in the Canadian commercial real estate market poses significant financial risks, potentially leaving property owners and tenants vulnerable to substantial losses. This issue has become increasingly pressing due to rising construction costs, inflation, the escalating frequency of natural disasters, and inadequate tenant insurance compliance. Understanding the causes, impacts, and mitigation strategies is essential to safeguarding investments.

Prevalence of Underinsurance

A considerable number of Canadian businesses are underinsured. A study by Deloitte revealed that approximately 25% of Canadian small businesses are either underinsured or lack commercial insurance coverage entirely. Furthermore, data from 2015 indicates that 81% of commercial properties in Atlantic Canada were underinsured by an average of 81%, equating to over $1.25 million per property.

Factors Contributing to Underinsurance

Inflation and Rising Construction Costs: Inflation and rising construction costs have significantly impacted the Canadian commercial real estate market, leading to increased expenses for property owners and developers. Several factors contribute to this trend:

Surge in Construction Costs:

Since the onset of the COVID-19 pandemic, residential construction costs in Canada have risen by 51%, vastly outpacing the overall consumer price index, which increased by 13% during the same period. – Global News
Non-residential construction costs experienced a 12.5% increase from 2021 to 2022 across Canada’s key metropolitan areas, marking the highest year-over-year rise since 1981. – Hub International

Factors Driving Cost Increases:

Material Costs: Building materials such as concrete and structural steel have seen price increases of 55% and 53%, respectively, since the first quarter of 2020. – Global News
Labor Costs: Labor shortages have driven up wages, particularly in Western Canada. Over the past 12 months, construction wage rates have risen by 8.4% in Calgary and Edmonton, and by 5.5% in Vancouver, Victoria, and Kelowna. – ConstructConnect Canada
Supply Chain Disruptions: Global supply chain issues have led to delays and increased costs in construction, affecting the ability to rebuild promptly after a loss. – Hub International

Regional Variations:

In the second quarter of 2024, residential building construction costs increased by 0.8%, while non-residential costs rose by 1.1%. Year-over-year, these costs saw increases of 4.2% and 4.3%, respectively. – Statistics Canada
Calgary experienced the largest year-over-year growth in residential construction costs at 7.3%, while Saskatoon led non-residential growth at 7.0%. – Statistics Canada

These escalating costs underscore the importance of regular property appraisals to ensure adequate insurance coverage, as outdated valuations may leave property owners underinsured in the face of rising reconstruction expenses.

Natural Disasters: Canada has experienced a significant increase in catastrophic weather events, leading to unprecedented insured losses. In 2024, insured losses from severe weather events surpassed $8 billion, marking the highest annual total in Canadian history and exceeding the previous record of $6 billion set in 2016. – IBC

This surge in natural disasters elevates the risk of underinsurance, as properties may not be insured for the full cost of potential damages. The escalating frequency and severity of events such as wildfires, floods, and hailstorms have resulted in a substantial increase in insurance claims. For instance, in just two months during the summer of 2024, four catastrophic events le

d to over $7 billion in insured losses and more than a quarter of a million insurance claims – 50% more than Canadian insurers typically receive in an entire year. – IBC

Tenant Insurance Non-Compliance: A notable concern is the high rate of tenants failing to meet their lease’s insurance stipulations. Over 70% of tenants submit proof of insurance that does not comply with their lease requirements. The primary areas of non-compliance include:

Additional Insureds: 71% of tenants incorrectly list or omit required additional insured parties, which can leave landlords unprotected in liability claims.
Certificate Holders: 60% of tenants provide incorrect information for certificate holders, hindering proper notification of policy changes or cancellations.
Business Interruption Coverage: 45% of tenants lack business interruption insurance, essential for covering lost income during unforeseen operational halts.
Property Coverage: 41% of tenants do not have adequate property insurance, leaving their assets and, by extension, the landlord’s property at risk.

Consequences of Underinsurance

Underinsurance can lead to severe financial repercussions for property owners and tenants alike:

Co-Insurance Penalties: Many insurance policies include co-insurance clauses requiring property owners to insure their assets to a specified percentage of their value, typically 80% to 100%. Failing to meet this requirement can result in penalties, reducing claim payouts proportionally.
Out-of-Pocket Expenses: In the event of a loss, underinsured property owners may have to cover the shortfall between the insurance payout and the actual reconstruction costs, which can be financially devastating.
Increased Liability Exposure: Without proper tenant insurance, landlords may be held responsible for damages or injuries occurring within leased spaces.
Policy Complications: Non-compliant tenant insurance can lead to disputes during claims, potentially delaying settlements and increasing administrative burdens.

Mitigation Strategies

To address underinsurance, property owners should consider the following actions:

Regular Professional Appraisals: Engage qualified appraisers to assess the true replacement cost of properties, ensuring insurance coverage reflects current values. To ensure adequate insurance coverage, Canadian commercial property owners are advised to conduct professional insurance appraisals annually. Regular appraisals help maintain accurate replacement cost assessments, aligning insurance coverage with current property values and mitigating the risks associated with underinsurance.

In addition to annual appraisals, it’s prudent to reassess property valuations whenever significant changes occur, such as major renovations, expansions, or fluctuations in construction costs. These proactive measures ensure that insurance coverage remains sufficient to address potential losses effectively.

Policy Reviews and Updates: Regularly review and adjust insurance policies to align with current property values and market conditions, accounting for factors like inflation and changes in construction costs.
Strict Lease Enforcement: Clearly outline insurance requirements in lease agreements and enforce compliance through regular audits and documentation checks.
Tenant Education: Inform tenants about the importance of adequate insurance coverage and the specifics of policy requirements to ensure mutual protection.
Utilize Compliance Tools: Implement systems or services that monitor and verify tenant insurance certificates, ensuring they meet lease specifications.

By proactively managing both property and tenant insurance compliance, Canadian commercial real estate owners can reduce the risks associated with underinsurance, safeguarding their investments and promoting a more secure leasing environment.