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Insurance: the new elephant in the room

Insurance is a necessary evil, in almost any business. 

More often than not, it makes economic sense to pay a premium to an insurance company for them to protect you against economic loss from extreme scenarios that could adversely affect the business. 

In multifamily real estate, lenders require that we buy insurance to protect their interests. So, as long as we are using leverage, we have no choice but to buy insurance. 

Unfortunately, costs for insurance have been increasing rapidly over the last few years and in particular in the last 3-4 months. Based on our assessment of the external environment for insurers, we expect that premiums could well continue to increase in the short term.

What is driving the increasing costs?

At its basis, insurance companies make an assessment of the frequency and severity of claims that they are likely to pay, and then add in a profit margin in order to come up with a premium to charge their policyholders.

Insurers argue that in recent times there has been an increase in the frequency of large insurance events (think: wildfires, tornados, winter storms, hurricanes), as well as an increase in the severity of losses from these events.

While some of the causes of these increases may be due to natural phenomena such as climate change, much of the increase can also be attributed to human intervention in the claims process. 

The legal system plays a valuable role in protecting policyholders from unscrupulous insurers, but it also serves to benefit those who want to take advantage of the system. In many jurisdictions, fraudulent claims have become a major factor that increases costs for insurers, and this has been evident in states such as Florida and Texas.

Inflation is now also a major factor. With inflation hovering around 7-8%, the cost of repairs is increasing, and insurers need to take this additional cost into account when setting their premiums.

Finally, the cost of reinsurance is increasing rapidly, and this is also going to have a major impact on the cost of insurance, as we move forward into 2023. Insurers tend to optimize their portfolios, by transferring the more extreme risks in their portfolio to reinsurance companies, and this is known as “reinsurance”. They tend to do this because it allows them to operate with a lower capital base, and this boosts the returns that they are able to offer their shareholders. 

Unfortunately, as the cost of reinsurance increases, so too does the insurer’s cost of capital and this puts additional strain on an already stressed insurance market.  

Can anything be done to reverse this trend?

As a result of all of the above factors, many insurers do not see the business to be as attractive as it once was. They are now either reducing their participations or withdrawing from the market altogether.

With less supply of insurers, the price of insurance has shot up in some markets. In response, political reform is now on the agenda in many jurisdictions, to try to create a more favorable environment for insurers, to encourage them to re-enter the market and to create a more stable insurance market for consumers.

While these political initiatives should be positive for the market, they will likely take some time to take effect.

Can we quantify the impact on operations of a multifamily asset?

On the types of assets that we buy, annual insurance premiums had increased from around $650 – $700 per unit in 2020, to around $850 – $950 per unit, per year by mid-2022. That is an increase of more than 30% in just two years.

Most recently, some insurance quotes are now coming in at more than $2,400 per unit!

Let’s put that cost into context:

  • On a typical 200-unit asset, we may be collecting total revenue of $2,000 per unit per month. So total annual revenue = $4.8M
  • Total expenses may be 45% of revenue. So, in this case that equates to $2.16M per year.
  • The difference between these two figures is the Net Operating Income (NOI) which is $2.64M.
  • Let’s also say that this property has an annual debt service of $1.8M. if we subtract this figure from the NOI, that gives us free cash flow of $840k per year, or $210k per quarter.

Now, let’s say that last year’s insurance cost $900 per unit, which totals $180,000, and that this year’s quote comes in at $2,400 per unit, which totals $480,000. That represents an increase in costs of $300,000.

In this example, $300k represents a reduction in annual free cash flow of 36% and effectively wipes out cash flow for one and half quarters!

What is the outlook and impact on multifamily?

As you can see from the example above, increasing insurance costs are going to put additional strain on the operations of some properties, especially in an environment where many are already facing increased debt service costs.

While insurance premium increases are already evident in coastal states such as Florida, The Carolinas and Texas, there is strong evidence to suggest that insurance premiums will increase in all parts of the country as we progress through 2023. Primarily because:

  • Reinsurance cost pressures are being felt across the US, not just for those insurers operating in States that are exposed to natural catastrophes 
  • Inflation is persistent across the nation

What can we do to mitigate these premium increases?

As mentioned above, as long as we are using leverage in the purchase of multifamily assets, adequate insurance is a requirement of the lender. Potentially, there will be an opportunity to amend coverage slightly to achieve some cost savings, however this is likely to only reduce premiums slightly, given that lenders are strict about which coverages they would like to see in the policy.

Some other strategies that may help to reduce cost, include:

  • Combining insurance policies on multiple assets and purchasing a group insurance cover that provides scale and diversification to the insurer. Depending on the operator’s ability to bundle and achieve scale, we have seen this strategy reduce premiums by 50% or more.
  • Increasing insurance deductibles on the primary policy and seeking to purchase a separate buy-down cover from a specialized insurer
  • Supplementing the insurance program with parametric solutions that operate based on a defined event occurring, rather than on indemnifying an actual loss

Alternatively, operators may choose to avoid high-cost insurance areas on future acquisitions. The downside of this strategy however, is that most often these high-cost areas tend to be high-growth areas too and you may then potentially miss out on strong performing markets in future.

A silver lining?

While increasing insurance costs will undoubtedly have an impact on existing assets in the short term, they will also create opportunities for the future.

As insurance costs increase, NOI decreases, and this will need to be recognized in the form of lower prices by any sellers that wish to dispose of assets in the current environment. 

The silver lining in terms of acquisitions may be that we will see the potential for artificially low property values that are caused by unsustainably high insurance premiums in the short term.

While our focus is to be proactive and prudent in the management of insurance on our existing assets, we will certainly also be on the lookout for buying opportunities caused by insurance cost pressures, as we progress through 2023.

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