Multifamily investors are facing an unprecedented challenge of rising commercial property insurance rates due to weather-related losses and rising construction costs, among other factors. Respondents to the National Multifamily Housing Council’s 2023 State of Multifamily Risk Survey note insurance costs surging an average of 26% year over year. We are identifying even higher premium increases in the target markets that comprise our multifamily investments. Why is this happening, and what steps are we taking to mitigate these increases as part of our risk-management strategy?
What’s Behind Commercial Property Insurance Increases
Global commercial property insurance rates rose 4% in the first quarter of this year, according to the Marsh Global Insurance Market Index, from Marsh, a prominent insurance risk advisor. That’s the 22nd consecutive quarter of composite rate increases; quarterly increases peaked at 22% in the 4Q 2020.
Insurance Rate Changes in Marsh’s U.S. Property Portfolio, by Quarter
As well, global property insurance pricing in 1Q 2023 increased by 10% compared with 7% in the prior quarter; in the U.S., property pricing increased 17%, compared with 11% over the same period, according to Marsh. The growing frequency and intensity of weather-related catastrophes worldwide are contributing to the rise in global insured losses as insurers strive to manage their risk exposure. The chart below, also from Marsh, demonstrates a staggering 162% surge in global insured losses (encompassing all property types) over the past five years compared with the preceding five-year period.
Trend of Global Insured Losses, 2012-22, In Billions
Inflation’s Impact on Property Insurance and Reinsurance
Inflation has a material impact on commercial property insurance rates by increasing claim costs, operational expenses and reinsurance costs, while reducing the purchasing power of investment income for reinsurance providers. These factors contribute to higher premiums for policyholders as insurers aim to maintain profitability in an inflationary environment. Rapidly rising material and labor costs have led to increased insurable values, exacerbating the effect of surging insurance rates. Insurers are also paying more attention to the insurable value of a property, placing greater emphasis on accurate replacement values, due to claims exceeding the basis on which premiums were paid.
The Federal Reserve’s monetary tightening in response to inflation has led to a decrease in the value of reinsurers’ bond-centric investment portfolios. If reinsurers have to address significant insurance claims, they may be forced to sell those bonds before maturity and realize losses. Higher interest rates offer investors alternative investment opportunities, potentially reducing capital flowing into the reinsurance sector.
Mitigating Risks for Multifamily Owners Amid Rising Rates
As insurance rates rise, carriers protect themselves by charging higher deductibles and providing less coverage for commercial real estate insurance. However, as has been shown, insurance costs have been increasing steadily for several years, and we have been incorporating expectations of increases into our due diligence. Here are a few other key strategies we are employing to mitigate risk and cost during uncertain times:
Early start on policy renewals: We begin policy renewal discussions well in advance of deadlines and get firm expectations from our brokers.
Data quality and modeling: We work closely with brokers and advisors to understand loss projection models and prepare clear data regarding insurable valuation methodology.
Risk retention: We understand the limitations of commercial property insurance for high-frequency/low-severity claims (such as resident “slip-and-fall” claims in an operating building). These types of claims can be costly for property owners because they often end up paying more than the value of the claim due to “dollar-trading” scenarios. This occurs when a property owner has multiple small claims in a short period of time, resulting in higher premiums and deductibles that exceed the amount of the actual claims. One alternative is to incorporate large deductibles to lower premiums and handle small claims independently.
Infrastructure and materials: For new apartment projects, we carefully consider how to incorporate robust fire/life safety infrastructure, flood mitigation technology and materials used to build the structure and finish interior spaces. This may result in higher upfront costs but can lead to lower insurance premiums and better coverage availability.
Review loss-control weak spots: This is done by addressing common hazards, structural issues, and health and safety concerns, and which can lead to improved insurance coverage or lower premiums.
While weather-related events will continue to have an impact on commercial real estate insurance losses and premiums, we will invest capital where there is a return on investment via lower future premiums. Over time, changes can be made to buildings to help them become more resistant to storms, fires and other hazards.
Alternative Risk Solutions to Consider
A hybrid approach of self-insuring specific tranches of catastrophic risk in combination with purchasing third-party coverage for smaller and more frequent loss exposure is worth considering. Other alternative approaches exist, as well.
At some point deductibles get large enough and small claims become frequent enough that it may make sense to consider creating a “captive insurance company,” which involves setting up a small insurance company owned in whole or part by the insurance beneficiary. Along with some tax advantages, this approach allows property owners to have more control over their own risk management strategy since they can customize coverage according to their specific needs. Some of the disadvantages include a potential loss of investment income due to the need for capital reserves.
Another alternative is parametric insurance, which uses predetermined metrics such as weather events as triggers for payouts when certain conditions are met or exceeded. If the weather reaches a predetermined threshold, then the insured gets paid, regardless of whether they sustain any damage. A parametric can help reduce costs associated with traditional insurance policies.
It is important to understand the requirements of loan and other third-party agreements to negotiate as much flexibility as possible to plan for future volatility in the market. Alternative risk solutions, such as captives, are typically not as effective in addressing large losses—and regulatory compliance is no trivial matter. These strategies likely work best as a part of an overall risk management program and for owners that have large portfolios and a significant spread of risk.
How Rising Insurance Rates Affect Our Target Markets
Florida, Texas and Arizona are important target markets for Origin’s multifamily investments. All three states are business-friendly, low-tax states with strong population and job growth. But all our markets have challenges—such as water management in Arizona—that come, literally, with the territory. For us, it all comes back to risk management: Instead of crossing our fingers and underwriting to best-case scenarios, we take a pragmatic, practical approach and incorporate these challenges into our deal structures. For instance, many of our current investments in both Florida and Texas have been developed at higher margins that can absorb some of these higher costs.
To be clear, no multifamily investments manager has been spared from rising insurance rates, inflation and weather-related events—and none, including us, could have predicted the speed and impact that these three factors have had. We started underwriting to more conservative levels before the explosion in premiums. And our approach is not to compromise on the scope of insurance coverage and take on additional risk. All the same, we expect to absorb the impact of these costs within our investments even as we execute our strategy of conservative underwriting, developing to margin and other actions to manage risk.
We can’t predict if and when insurance costs will decline; for the time being, future deals may not meet our required return on costs. We enter all our markets with realistic perspectives on their advantages and potential drawbacks, and with an assiduous approach to mitigating cost and risk in our multifamily investments, from groundbreaking to disposition.