This post is a guest article by Danielle Lombardo, Chair of Lockton's Global Real Estate Practice. Danielle’s technical insurance expertise coupled with her knowledge of the real estate industry allows her to provide strategic risk management advice for her clients.
We are at a crucial inflection point where rising insurance costs are hampering new development and acquisitions, and real estate owners and developers are looking for relief from one of the most challenging insurance markets in history.
Trading dollars with insurance carriers is not an efficient use of capital, especially at current pricing levels. Real estate firms need to hedge against future premium volatility by exploring risk finance strategies that reduce inefficient or costly risk transfer. The challenge with real estate firms taking on more risk? Being handcuffed by lender insurance requirements.
Lender insurance requirements often dictate more coverage than industry models would deem necessary and limit deductibles or retentions that could help offset significant premium increases with limited additional exposure to loss. Properties are therefore often over-insured to cover extreme losses that rarely occur. The cost to comply with these requirements can literally strip the cashflow out of deals.
Since early on in my career, I've been passionate about solving the disconnect between various stakeholders in the real estate transaction: lender, borrower, and the insurance industry. There are significant efficiencies to be gained by working together and using a data-driven approach to allocate risk appropriately.
Here, I’ll share my thoughts as well as some thoughts from Amy Blackman, MAI, Regional Managing Director for the Southeast and Midwest Regions for Apprise, and Brian Moulder, Managing Director of Investment Sales for Walker & Dunlop, about what is happening right now and what can be done to create widespread change to a systemic problem.
Why new CRE development is challenging
The increase in insurance costs is stripping cashflow out of deals and halting new development. The increase is making clients question whether they should do business in certain states such as Florida and Texas. Although rates are rising nationwide, the problem is most acute in states experiencing a growing number of extreme weather events that include hurricanes, winter freezes, floods and wildfires.
Florida is the riskiest piece of land in the world, yet it’s also one of the most attractive to developers because of its substantial population growth. But sky-high insurance costs pose a challenge for developers looking to keep up with the demand for CRE.
First, there’s an insurance supply-and-demand issue, particularly in Florida. As Blackman noted: “Insurance is a requirement and there are only so many carriers that can insure a property.”
Fewer carriers are willing to underwrite development in areas such as Florida and Texas, and scarcity leads to costlier premiums.
Especially in Florida, we see a large number of costly natural disasters. As companies have to pay out more in losses than they collect in premiums, more and more insurance companies move to the sidelines, leading to a declining number of providers. “Who the remaining insurance companies choose to insure becomes very selective,” shared Amy Blackman, MAI.
Moulder echoes this thought, noting that cost is often tailored to the individual buyer. “This is one of the biggest challenges for us as we try to price insurance for our customers. It’s difficult for us to pinpoint what the insurance will cost because we don’t know who the buyer is.”
Blackman also points to a lack of control over insurance costs. “You can negotiate payroll costs, repair expenses, maintenance, etc. That’s not the case with insurance, which is why this line item is so heavily scrutinized.”
These risks aren’t exclusive to Texas or Florida, either. Across the country, we’re seeing weather events and natural occurrences like never before: wildfires, severe convective storms, baseball-sized hail, and winter freeze storms causing billions of dollars of damage. Through June, US Q2 catastrophe losses are projected to be in the range of $20B -$27B, double the 10-year average of $12.5B. Over 90 percent of US counties have experienced natural disaster, and insurance companies are bracing for continued uncertainty in weather patterns by limiting insurance limits, restricting coverage grants and raising pure premium rates.
Creative ways to secure more affordable insurance
It used to be that just the coastal markets would see higher insurance costs and understandably so. But now, we’re seeing more of what Moulder calls a “blanketed approach” that applies to the entire state. “In Florida, it doesn’t matter whether you’re inland in Orlando or on the coast of Miami. It also doesn’t matter what product type the asset is.”
In some cases, we’re seeing developers, investors, and owners paying for more insurance than they need. I’ll give you an example: A 732-unit residential property in Corpus Christi has a $40 million total insured value (total replacement cost + annual rents). In today’s market, the cost to insure that asset is $3.7 million.
Taking a data-driven approach, the models anticipate the loss will not go above $10 million. The cost for coverage at $10 million vs. $40 million reduces the premium to $2.7 million—the difference between cashflow and foreclosure. It’s the deciding factor between a deal transacting and not transacting.
This is an example we’re seeing every day across the country. We’ve reached the point where many developers are taking on millions of dollars of risk they didn’t have to take on before through higher deductibles as well as purchasing lower limits.
The key is building a process and infrastructure to support this new exposure to the balance sheet.
The role of data in curbing insurance expense for CRE development
As part of the Insurance Regulatory Group via the Mortgage Bankers Association, what we’re advocating for with the lending community is to realign lender insurance requirements with reality and create a more efficient process. We aim to help lenders understand that taking a more data-driven approach helps to avoid creating insurance scarcity.
Underwriters and brokers have access to catastrophe models (for flood, wind, and earthquake) that offer decades of historical storm data. They overlay this data with building characteristics to come up with the probable maximum loss at various return periods. That amount is usually a fraction of the total insured value (which is what the lender currently requires).
Using catastrophe models to allow for more practical limits of insurance would significantly reduce premium outlay and help fix part of the supply demand issue in the insurance market.
Lenders, borrowers, and insurers need to come together to agree on efficient risk allocation and non-traditional risk finance mechanisms to keep deals moving.
Where to go from here
Ultimately, it’s all about going back to the drawing board and looking at insurance as a business decision for lenders. The current approach has reached a fever pitch that’s going to cause a complete halt in the industry. Embracing slight uncertainties to lower insurance limits could allow more deals to prosper — a feat that will create a positive trickle-down effect for housing, services, and overall quality of life.
So, how do we solve for this? In an insurance market that lacks competition, the focus needs to be on buying less insurance and taking on more risk:
- Taking a data-driven approach to buying catastrophe coverage and increasing deductibles will provide the most immediate premium relief.
- Long term, real estate firms need to hedge against future volatility by exploring risk finance strategies. Trading dollars with insurance carriers is not always an efficient use of capital, especially at current pricing levels.
- Building a risk management infrastructure to support more sophisticated insurance programs is key to long-term success.
Moulder encourages developers, owners, and other CRE stakeholders to reach out to their trusted commercial real estate advisors and brokers to explore potential options.
Many real estate owners are questioning their insurance broker relationships. It’s hard to delineate insurance marketplace realities from insurance broker negligence, but focusing on the following factors should tell you if you are with the right partner or if a change is necessary:
- Team focused exclusively on real estate
- Global and regional insurance carrier access
- A process around running multiple approaches to exhaust all options (master program, bifurcated, stand-alone)
- Risk Finance/Captive expertise
- In-house reinsurance
- Relationships with key lenders to support the waiver process
- Access to analytics to support decision making
- A process for all aspects of the engagement with accountability project management support
- Expertise and process around building a risk management infrastructure
The time for change is now. Lenders, borrowers, and insurers must come together to develop efficient risk allocation and non-traditional risk finance mechanisms to keep deals moving and CRE development strong.
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