Fire Sprinklers and Homeowner Insurance

Fire Sprinklers and Homeowner Insurance
Special Studies, September 14, 2007
By Lanlan Xu
 
Report available to the public as a courtesy of HousingEconomics.com
 
The issue of installing fire sprinklers in homes raises a number of questions. To what extent are sprinklers able to prevent injuries or property damage due to fire? Is it enough to justify the added cost of sprinklers? If so, what is the impact on housing affordability, and are there any factors that can help offset the added cost?
 
The issues would be somewhat simplified if we could show that monetary savings existed to offset, or almost offset the added upfront costs of installing fires sprinklers. Builders in that case would be able to install sprinkler systems in most new homes and market the sprinklers effectively to prospective buyers as an added safety feature that pays for itself.
 
Fire sprinkler proponents sometimes allege that such savings already exist in the form of reduced rates on home owner insurance. This article studies that particular issue. From the insurer’s point of view, sprinklers may generate savings, but also additional costs. Savings to insurance companies occur if sprinklers extinguish fires in their early stage or contain fires until the fire fighters get to the scene —resulting in reduced injuries, deaths, and property damage. Additional costs may occur if sprinklers discharge accidentally and cause unnecessary water damage. Insurance companies thus have both the means and incentive to track savings and costs associated with sprinklers. If the expected savings are greater than the expected costs, it should show up as discounts on insurance for owners of homes with fire sprinklers. Information compiled from various sources for this article indicates that most insurers do offer meaningful discounts for residential sprinkler systems. The discounts vary somewhat from state to state, but are not high enough in any state to offset the added upfront cost buyers pay for sprinklers.
 
Sprinkler Discounts by State
In each state, NAHB obtained data about the practices of the top insurers. In some cases, the data could be obtained from state government departments of insurance. In others, it was necessary to contact insurance companies or individual agencies. Data were compiled on insurers that cumulatively have at least 40% of the market in every state (including DC) except for Hawaii, where the cumulative share covered is 23.6%. [1] Some insurance companies, like State Farm and Allstate, have large market shares in many states, but there are also states where the market is spread more evenly at the top and includes a number of regional companies, particularly in New England. (Table 1)
 
Although a few of these regional insurance companies such as Indiana Farm Bureau and Kentucky Farm Bureau do not currently offer discounts for fire sprinklers, they are the exceptions. Most insurance companies do offer discounts, most often in the form of a percentage off the basic premium. To qualify for the discount, the sprinkler system has to meet the National Fire Protection Association standard. [2]
 
Insurance companies generally make a distinction between two types of sprinkler systems: Class A, where automatic sprinklers are installed in all areas including bathrooms, attics, closets, and attached structures; and Class B, where automatic sprinklers are totally or partially omitted in bathrooms, attics, closets, and attached structures. Insurance usually, but not always, offers different discounts for each type of system. Many discounts are in the neighborhood of 10% for Class A sprinkler systems and 5% for Class B systems. In fact, companies like State Farm and Farmers Insurance offer a uniform 10% and 5% in all states except for in North Carolina. [3] Other insurance companies offer different discounts in each state. Among the companies shown in Table 1, the maximum discount is 16% for Class A systems , and 10% for Class B systems. [4]
 
The same percentage doesn’t lead to the same dollar savings for all new home buyers, due to differences in insurance rates, coverage, and values of the homes purchased, which vary by state. Table 2 shows median new home prices (estimated by NAHB for 2007), median insurance costs paid by new home owners (calculated from the Census Bureau’s 2005 American Community Survey and based on homes built after 1999), and average fire sprinkler discount rates in each state. The discounts in Table 2 are weighted averages of the discounts in Table 1, with the weights based on the companies’ market shares.
 
Without more information about the type of policies on which the median insurance payment is based, it’s impossible to calculate with precision how much buyers can expect to save on the average new home with a sprinkler system. The best we can manage with the data in Table 2 is a rough upper bound. Using the average insurance payment as a crude proxy for the basic premium [5], the most an average new home buyer in a particular state can expect to save on homeowners insurance appears to be about $95 a year. This is in Florida, where the average annual insurance payment and the average sprinkler discounts are both relatively high. As mentioned, the $95 in annual savings are an upper bound that almost certainly overstates the savings somewhat, as the average insurance payment is likely to include charges beyond the basic premium, and the discount applies only to the basic premium.
 
Beyond that, the added savings attributable to fire sprinklers will usually depend on the home’s other safety features. Most insurance companies offer discounts for devices such as dead bolt locks, smoke detectors, fire extinguishers, burglar alarms, etc. Although the discount offered for each kind of safety device varies, there is normally a cap on the combined discounts for all safety devices, usually at 20%. This means that, given a large enough number of other safety features, the marginal impact of a sprinkler system on the insurance payment could be very small or zero.
 
Cost of Fire Sprinklers
How do the potential savings on homeowners insurance compare to the costs?  At times, different organizations have cited different cost figures, not always documenting the source. For example, in its brochure for consumers titled “Protect What You Value Most”, the Home Fire Sprinkler Coalition simply states that a good rule of thumb estimate is to add 1 to 1/½ percent to the cost of new housing. Applying this general rule to the $246,500 median price of a new home sold in 2006 [6] is $246,500 translates into a $2,465-$3,698 increase in its price.
 
In 2007, Home Innovation Research Labs collected information on sprinkler costs in a nationwide survey completed by 102 builders who built 5,527 homes with fire sprinklers in 2006. The survey results show that the median cost of installing fire sprinklers in the 5,527 homes was about $5,573 (Table 3). The median size of the surveyed homes was 2,271 square feet, very close to the 2,248 square feet reported by the federal government for homes built in 2006. [7-8]
 
The extra costs Home Innovation Research Labs' survey was careful to include are the costs of increased permit, tap, and inspection fees, as well as any costs of redesigning the home to accommodate the sprinklers. It’s important to include these items, as costs are not limited strictly to the material and labor used in installing the sprinkler system itself.
 
In addition, the increase in price to the home buyer will generally be more than the increase in the construction costs. This occurs because, when construction costs rise, other costs such as financing costs and broker commissions also rise. Moreover, normal profit margins must be maintained to keep home building competitive and prevent the capital and entrepreneurship from moving to other industries. Based on these factors, NAHB estimates that a $5,573 increase in construction costs will raise the final price of the home to the buyer by $6,677 (Table 4).
 
One way to put this in the same time frame as the annual savings on homeowners insurance is to assume that the $6,677 is financed and see by how much that would increase the buyer’s annual mortgage payment. Using Freddie Mac’s 30-year fixed-rate mortgage rate of 6.70% in July 2007, a $6,677 increase in the amount of the mortgage translates to an increase of $522 in the annual payment, roughly 5½ times the upper bound of the amount the average new home buyers could save on their insurance premium in any state. Even under the lowest of the above cost estimates ($2,465), the annual mortgage payment would increase by $193, roughly double the upper bound on the average insurance savings.
 
An added factor is that home buyers will take insurance savings into account when making their purchase decisions only if they understand the magnitude of the annual savings and believe these savings to be real and long lasting. Federal or state agencies could help achieve this by monitoring the insurance industry and compiling data to show that accidental sprinkler discharges do not in the long run lead to cancelled policies or increased premiums.
 
Moreover, the above costs included only the initial installment costs to homeowners. A fire sprinkler system has to be maintained. Although homeowner insurance usually covers damage caused by water discharged from the sprinkler system (even if the discharge is accidental) it does not cover repairs to the sprinkler system itself. In addition, the damage caused by water leaking from the system slowly over a long period of time, such as rot, is not covered. These items can all add to the annual cost of the sprinkler system to a homeowner, although probably not by much in the first few years after a typical new home is purchased.

Summary and Further Discussion
This article looks at the dollar costs of fire sprinklers to home builders and  home buyers, and compares these costs to the dollar savings buyers can obtain on homeowner insurance policies. Buyers may have other reasons for desiring for fire sprinklers, such as an added sense of security it gives them, but this article looks only at the dollar savings available to them on insurance policies.
 
The article found that most, but not all, insurance companies offer discounts on homeowner insurance policies for sprinkler systems. The data, although incomplete, are enough to establish a rough upper bound of $95 on the average annual savings to new home buyers in a particular state. This represents a substantial and significant discount, but only modestly offsets the increase in price for a typical new home buyer (for which estimates presented in this article range from $2,465 to $6,677).
 
Under prevailing interest rates, a $95 savings in annual insurance cost is able to fully offset the increase in mortgage payments only if the up-front cost of the sprinkler system to the home buyer is approximately $1,200 or less. Reducing the cost of producing and installing the average Class A residential sprinkler system to somewhere in the neighborhood of $1,200 would thus be a worthwhile goal. If achieved, it would allow the market to provide sprinkler systems in most new homes without adversely affecting affordability. Local governments could make a contribution toward achieving this by not increasing permit, tap, or other fees on homes with sprinkler systems.
 
 
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Footnotes:
 
[1] Based on the National Association of Insurance Commissioner’s 2005 Market Share Report by State (04-Homeowners Multiple Peril), major insurance companies that cumulatively have at least 50% of the market share in all 50 states and the District of Columbia are selected for the survey.
 
 
[3] In North Carolina, there is a uniform discount rate of 13% for Class A sprinkler systems and 7% for Class B systems. Insurance companies have to file any intended changes from these rates and have them approved by the state. So far only Auto-Owners has filed for a 15% discount on both Class A and Class B systems.
[4] Although Concord Group in Maine reports a 20% discount for Class A, the discount only applies to the situation where fire sprinkler system is combined with central alarm system, fire distinguisher and smoke detector.
 
[5] The discounts in Table 1 apply to the basic homeowner insurance premium. Based on the information contained in the American Community Survey, there is no way to calculate a relationship between basic premium and final premium. The premium paid by the owner will generally be higher than the basic premium if the homeowner chooses additional coverage for items like jewelry or fur, or additional replacement cost protection.
[6] “Characteristics of New One-Family Houses Sold,” U.S. Census Bureau.
 
[7] “Characteristics of New One-Family Houses Completed” U.S. Census Bureau.
 
[8] While the response rate of the survey is unknown for several reasons, the median square feet of houses surveyed is close to the Census’ number, suggesting that selection bias is probably not an issue.

For more information about this item, please contact Paul Emrath at 800-368-5242 x8449 or via email at pemrath@nahb.org.


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