Managing and Budgeting Insurance for your Facilities

As year’s end slowly comes into view, it’s budgeting time for many companies, and an annual problem arises: how to budget for something as unpredictable as the cost of insurance? Rates can climb quickly for several years and then turn around just as quickly and fall for several years after that. The insurance industry goes in cycles—that much history tells us—but how long and steep the cycles will be one can only guess.

We do know that the cycle right now is being kind to insurance buyers. Rates are down and that certainly makes the budgeting task easier. We are also seeing some changes in the insurance industry that have the potential to change the nature of the insurance cycle itself. The roller- coaster ride of the past cycle was so violent that the industry may be evolving in ways that will smooth out the cycles.

That being said, all can change overnight—with the turn of a hurricane’s path, a shift in the earth’s crust or the shock of a man-made catastrophe. What forces shape the cost of risk for real estate companies and what are the factors that influence the insurance cycle? And most importantly, what can a real estate company do about it?

What Drives the Cost of Risk?

Terrorism. We put this at the top of the list of cost drivers even though the risk of terrorism varies widely according to geography and property type. For those in major cities, and those involved with potential target properties such as convention centers, stadiums, tunnels, bridges and other landmark structures, terrorism insurance is a top-priority issue. Others will only be affected as activity in the terrorism insurance marketplace sends ripples across other lines of business.

Currently, the federal government supports the terrorism insurance market through the Terrorism Risk Insurance Act (TRIA), first passed in 2002, extended in 2005, and now set to expire December 31 of this year. On September 19, the House of Representatives passed a bill, HR 2761, to extend TRIA for 15 years and expand its provisions. The future of the bill is unclear, as the President appears prepared to veto it. We believe, however, that TRIA will be extended in some form. If not, insurance costs for sites with high terrorism exposures could skyrocket—or insurance may be unavailable at any price. This issue has the potential to dominate all insurance discussion, depending on the outcome of the legislative process.

Multiple Catastrophic Events. The last several years have brought the largest catastrophic losses in history, including the 9/11 attacks and the hurricanes of 2004 and especially 2005. The industry was hit hard, but rebounded by raising rates and building reserves for the future. A light 2006 hurricane season left insurers with record profits and a surplus approaching $500 billion, almost twice the industry surplus in September 2001. Given the good news, insurers could afford to reduce rates in an effort to attract clients—and in the process demonstrated the essential forces that create the insurance cycle. A disaster occurs and claims are paid; rates rise to cover the costs and surplus grows; insurers compete for market share and rates fall. The period of rising rates is called a hard market and the period of falling rates is called a soft market.

Multiple catastrophic events, or mega events, could disrupt the cycle altogether. Experts estimate that if the 1926 Miami hurricane struck today, damages could reach $130 billion. A category 3 hurricane—a moderate storm—in the Northeast could yield $300 billion in losses. Legislators and industry leaders are discussing the possibility of a TRIA-like fund to support the industry during a worst-case situation. What those efforts will yield, and what nature has in store, only time will tell.

Cost of Catastrophic Insurance. Real estate isn’t the only industry where location is crucial. The cost of insurance depends on exposure. In the U.S. 53 percent of the population lives within 50 miles of an ocean. The greater the exposure to disasters, the greater the cost of insurance protection.

Deductibles. Premiums are not the only cost of risk. Deductibles, also called retentions (because the insured party retains that portion of their exposure instead of transferring it to an insurance company), are also part of the calculation. After the hurricanes of 2004-2005, underwriters raised the deductibles for insurance buyers in highly exposed areas. Deductibles of two percent rose to as much as 10 percent and were commonly in the five percent range. We believe that even if rates decline, deductibles will remain at the higher levels.

Security. Terrorism fears plus the increasing likelihood that a personal assault will lead to a lawsuit against the owner of the property where the incident occurred have made insurers look closely at security measures in pricing liability insurance. This puts companies under pressure to hire security staff and install electronic security systems, including cameras and x-ray machines. These measures are expensive, but can drive down insurance costs in two ways: they can convince insurers to lower premiums, and more importantly, they can reduce claims.

Green Construction. Sustainability is becoming more popular as a construction principle. Thousands of buildings are awaiting LEED certification, and the trend is expected to continue. Like security measures, green construction can be expensive, but may also have a positive effect on insurance rates. One insurer is offering a five percent discount for LEED buildings. They believe that green construction makes these buildings better risks.

Benchmarking. Most real estate managers want to know what insurance their peers are buying, including rates, limits and deductibles. Your insurance broker should be able to deliver that information, which may influence your insurance decisions, especially in a competitive environment.

Pandemics. Avian, or bird, flu remains in the news. While the current strain of avian flu virus has not mutated into a form that can easily infect humans, pandemics represent a potential catastrophic event for which little insurance is available. Companies should develop crisis management and business continuity plans to respond to a potential outbreak. The cost of risk includes not only premiums and deductibles, but reducing the potential for loss, known in the industry as loss control.

Cost of Construction Materials. Demand from Asia is driving up the cost of materials such as copper and steel. Cranes are in such high demand that rental costs have skyrocketed. How does this effect insurance? If a building is destroyed, property insurance may provide the cost to rebuild the structure—but if the cost of rebuilding goes up because the cost of materials goes up, the insurance payment may not be sufficient. Companies should be sure to update the reported values in their insurance policies.

Lawsuits. The cost of civil lawsuits, or torts, grows as our culture becomes ever more litigious. This has a direct bearing on the cost of liability insurance, which covers the costs of court cases and settlements. Tort reform is afoot in many states, and this may, over time, reduce the cost of this coverage.

What Drives the Premiums That Insurers Charge?

We’ve looked at the insurance issues facing real estate companies. Now let’s take the insurers vantage point.

Cost of Reinsurance. Insurers buy insurance themselves to protect against the risk that they will have too many claims to pay. This is called reinsurance. Reinsurance companies were hurt by the costly hurricanes of 2004-2005 and raised their rates. These costs were passed along in turn by insurers to their customers. The price of reinsurance is always a key driver of premiums that insurers charge.

Capital Markets. As reinsurance rates rose steeply, Wall Street saw profits to be made and financial companies offered capital in the form of catastrophe bonds, or cat bonds, as an alternative to the reinsurance markets. In 2005, the capital markets offered $1.99 billion in cat bonds. In 2006, the figure more than doubled to $4.69 billion. The competition with reinsurers lowered reinsurance rates and contribute significantly to the current soft market. Will the capital markets remain interested? If they do, will their involvement have a softening effect on the next hard market turn in the insurance cycle?

Modeling. Insurers use computer models to make underwriting decisions, including price. Models were recalibrated after the spike in hurricane activity in 2004-2005, increasing the projected potential losses to insurers and hence the premiums charged for coverage.

Rating Agencies. Financial companies, including insurers, are monitored by rating agencies, such as Standard & Poor’s and AM Best. Ratings have a powerful influence on investors, and so the comments of the rating companies are taken seriously by insurance companies. After Hurricane Katrina, rating agencies grew concerned that insurance companies did not have sufficient reserves to cover multiple disasters and raised the capital requirements for companies to receive positive ratings. Insurers mostly responded by setting more money aside, leaving less capital available for underwriting.

Policyholder Surplus. The huge surpluses generated by the last hard market cycle means that insurers can now afford to sell more insurance. As supply goes up, price goes down. This is one of the key drivers of the insurance cycle.

Loss Ratios. Another measure of insurer results is the ratio of premium collected to claims paid. If the ratio is under 100—more is collected than paid out—then an underwriting profit is made. Loss ratios can be over 100 and insurers can still be profitable because underwriting is not the only way insurers make money. The 2006 loss ratio for the industry overall was 92.4, the best figure in decades.

Expected return on equity. Historically, insurance companies produced a lower return to shareholders than the typical Fortune 500 company. Expectations are changing. Shareholders are demanding the highest possible return, and one way insurers are responding is by using surplus to buy back shares of stock. This change may have a strong influence on the insurance cycle. If surplus is used to support stock price, and not to increase the insurance supply, this could potentially reduce the volatility of the cycle.

This article provides a general overview and discussion and is not intended, and should not be used, as a substitute for professional advice in any specific situation.

About the author: Brian Ruane is executive vice president and director of the national real estate and hotel practice group with Willis Group. Ruane is a 23 year veteran with Willis Group who specializes in helping real estate and hotel clients resolve insurance and risk management issues. He can be reached at ruane_b@willis.com.