February 23 - 2022
Underwriting is utilized in nearly every aspect of commercial real estate investing, including appraisal, purchase, sale, loan offering, and insurance services. Underwriting is the process through which an individual or institution takes on financial risk for a fee. This risk typically involves loans, insurance, or investments.
The Construction, Occupancy, Protection, and Exposure (COPE) framework represents a set of risk criteria that property underwriters review when determining whether to offer an insurance policy or move forward with a commercial real estate deal.
When it comes to underwriting analysis, the construction component is based upon:
Age of the structure
The construction component of COPE underwriting information analyzes the materials a structure was constructed with, the building’s age, quality of the property’s systems, and location. This information helps determine the risk to the commercial real estate property if it is exposed to forces that could cause damage.
Construction - Materials & Location
One of the primary goals of underwriting for any property insurance policy is determining the risk of fire. This analysis takes into account materials, the percentage of each material in the structure, and the potential overall damage in the event of a fire. In order to help determine the risk, the Insurance Services Office (ISO) outlines six construction classes.
Construction Class 1 — Frame
Construction Class 2 — Joisted masonry
Construction Class 3 — Noncombustible
Construction Class 4 — Masonry noncombustible
Construction Class 5 — Modified fire resistive
Construction Class 6 — Fire resistive
Class 1 Frame construction buildings typically have roof, floor, interior walls, and supports made from combustible materials, such as wood. They may also be buildings with exterior walls of noncombustible or slow-burning construction with combustible floors and roofs.
On the other end of the spectrum are Class 6 Fire Resistive constructions made from materials such as solid masonry, reinforced concrete, and structural metal supports.
The location also factors into the construction aspect of underwriting. For example, in a location where tropical storms and hurricanes are common, solid building materials and support structures are critical. This is one example of how construction might have a different impact on underwriting depending on location.
Construction - Square Footage & Age
The size of the property has a direct relationship to a potential risk of damage or loss. Square footage helps determine the building’s “maximum possible loss” (MPL) versus its “probable maximum loss” (PML). In the event of a fire, for example, for very large structures, a total loss is less likely. Therefore, the PML (in terms of total percentage loss) decreases with the size of the building. Meanwhile, a smaller building may experience 100% destruction in the event of a fire.
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A building’s age also factors into the underwriter analysis. An older building’s roofing, plumbing, HVAC, and electrical systems are more prone to malfunction, failure, or damage (such as an electrical fire).
Systems maintenance and updates have a direct impact on property risk and value. The timing and extent of updates and renovations should be considered as well. An older building that is well maintained has less risk compared to one that has been neglected for years.
Also, local construction-related laws and ordinances may have gone into effect after the structure’s original construction. The cost of bringing a building into compliance with local building codes can impact insurance and investment decisions.
Commercial real estate insurers and investors want to know who occupies a building and how the building is used. A warehouse may be occupied by a few dozen workers who work there during the day. This risk can be compared to a high- rise apartment complex with hundreds of people who live there.
Underwriting is also affected if occupants are primarily owners or renters. The type of activity that goes on inside a property also impacts risk evaluation. Are they making toys or working with volatile chemicals? Is the building a shopping center, office, factory, or residential complex? Plus, how are potential hazards managed? Answers to these questions affect the Occupancy element of underwriting analysis.
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In the COPE framework, any factor that improves the protection of a property is factored into commercial real estate underwriting. For example, does the building have interior sprinklers in case of a fire? Is there a fire station nearby the property? Even city infrastructure can be evaluated which can impact firefighter arrival speed or even the water pressure required to generate a powerful fire hose stream.
Other factors to consider are fire alarms, fire extinguishers, fire doors, and firewalls. The building’s history of fire code compliance may also be examined in the underwriting analysis.
This COPE insurance underwriting category examines the risk of the surrounding geographic area near the building. For instance, is the property located in a zone with a high risk of flooding, wildfire, strong winds, or earthquakes? If nearby factories work with potentially explosive or hazardous materials, this also affects a property’s risk profile. Occupant risk attributes can also be factored into exposure analysis.
The COPE underwriting framework items aren’t the only factors underwriters consider when evaluating risk. To cover other key underwriting indicators, click here.