As the risks and costs of the effects of climate change become increasingly clear to investors, many are considering complex new strategies to try to tamp down or mitigate the rising costs of CRE property insurance.
Not only are insurers raising premiums and imposing stricter underwriting standards, lenders are doing so too – in some cases exceeding the hazard-based recommendations of insurance brokers – and pumping up the costs for borrowers even more.
The challenges and opportunities are discussed in “Insurance on the Rise: Climate Risk and Real Estate Investment Decisions,” a new report by the Urban Land Institute and Heitman, a global real estate investment management firm, which is based on interviews with experts in the field.
The report blames the rising costs of property insurance on the higher frequency of weather-related claims, expensive and scarce reinsurance, persistent inflation, and regulatory restrictions. For owners, the consequences of higher premiums may include lower net operating income, failed deals, and declining valuations.
“In response, investors have been forced to retain additional financial risk while working to assemble a cadre of multiple insurers to provide the coverage levels needed,” the report stated. “They are devising new approaches to managing risk by stitching together coverage from multiple insurance carriers and employing alternative risk-financing solutions such as captives and self-insurance.”
Layered coverage through a consolidated master program is one option. This allows dozens of insurance carriers to be involved in a single coverage plan. A buffer layer can also be created. “This involves securing additional policies to cover specific loss windows above the primary coverage limits, such as acquiring extra protection against natural disasters when the primary policy’s limits are exceeded, but with a clear demarcation of liability for losses within certain thresholds,” the report noted.
Expanded deductible arrangements are also possible. Many property owners may attempt to keep insurance costs in line by agreeing to pay higher deductibles. Others are considering “aggregate deductibles” that apply a single deductible to all claims within a policy period instead of traditional per-occurrence deductibles. Such policies, however, may conflict with lender requirements.
Some owners are turning to self-insurance. That means companies assume a portion of the risk, either individually or as part of a self-insurance risk pool. The process requires evaluating the estimated losses versus the premium savings from not insuring the building. Legal and regulatory prohibitions may exist, and some lenders worry about balance-sheet impacts. A number of investment managers were also considering adopting captive insurance by which a business owner sets up an insurance company to insure its own risks.
Some specialty insurance carriers in the U.S. are increasing the use of “excess and surplus line” coverage designed for high-risk exposures traditional insurance carriers won’t cover, especially in states at high risk of natural disasters with a large number of multifamily buildings. “This shift has made E&S insurers a vital alternative for coverage, with their market share surpassing 9 percent of direct written premiums in 2023,” the report commented.
Another type of protection that is gradually being adopted is parametric insurance, which pays out in the event of specified “trigger events” instead of on the basis of losses incurred. As an example, the report describes a possible parametric wind cover policy that applies to “a sustained wind of Category 3 and above for a sustained period of one minute within a defined radius.”
Owners should also be prepared for underwriters to demand more detailed information, such as specific data on building performance for windstorms or resilient design information. Failure to do so can lead to increased premiums.
“One critical piece of data is the roof’s age, as it significantly influences vulnerabilities to wind and water damage, affecting insurance coverage and premium calculations,” the report noted. It added that owners may find their commercial roof damage claims denied if the stated age of the roof is not correct.
Construction type and condition are also important to insurers, with some reportedly reserving their full capacity for best-in-class accounts. Insurers are also free to adjust their rates each year, while owners of buildings with fixed-rent commercial leases have to deal with rising insurance costs, spurring some investors to seek opportunities to invest in net-lease properties that allow the asset holder to transfer some risk to the tenant, the report noted.
To make it all work, interviewees recommended starting insurance renewal discussions early and working closely with knowledgeable insurance brokers in a process they said has become significantly more complex. “Managing insurance costs effectively involves cultivating strong relationships with pivotal industry stakeholders, including lenders, regulators, and investors,” the report noted.
In addition to traditional insurance brokers, some owners turn to third-party consultants to help out, others rely on in-house insurance experts. A structured process that ensures high-quality data and open lines of communication is advised.
Despite these complexities amid uncertainty about the future of commercial property insurance, the report found investors continue to invest in high-risk regions. However, they are being more cautious about such investments and modifying their portfolios accordingly. “Leveraging a portfolio’s size and diversification across geographic regions and asset types could make their policies more attractive to insurers,” it said.
Meanwhile, investment in high-risk areas has not been deterred, though there is now more focus on predicting and mitigating insurance-related risks. “Investors have yet to identify a reliable way for predicting insurance costs, though some are piloting methodologies they hope will pay off,” the report said.