Insuring tomorrow: commercial real estate and the rising cost of insurance
Intensifying concerns regarding extreme weather events not only had an impact on real estate prices, but have also substantially elevated insurance costs for commercial real estate investors.
Insurance serves as a crucial tool to hedge properties against a broad spectrum of risks. But it also stands as a noteworthy expense in the overall cost of investing in commercial real estate. And, over the past few years, insurance expenses for commercial real estate have experienced a substantial increase, rising by 19% (YoY) in the second quarter of 2023 compared to 17% (YoY) in the first quarter of 2023. On average, insurance expenses have risen by approximately 8% since 2017. For multifamily assets experiences, the annual rise in insurance costs is even higher, at 10% across the U.S.
Multifamily insurance costs and US natural disasters
The increase in insurance expenses for multifamily properties appears to be linked to at least three main factors. First, inflation, which in turn has impacted general operational expenses, replacement costs and reinsurance costs. Second, there are concerns related to moral hazard from claims exceeding the agreements for which premiums are paid. This has led insurers to intensify their monitoring activities regarding the property's value, resulting in more accurate replacement values, and ultimately leading to an increase in insurance premiums to offset potential future misalignments.
The third factor is related to climate risk, and the elevated probability of extreme weather events causing damages. This poses a significant risk to insurers, reducing reinsurance capacity. In 2021, insured natural catastrophe losses exceeded $100 billion globally, with 71% of these losses occurring in North America. Figure 1 illustrates this trend. The growth in insurance premiums appears to closely track the costs of billion-dollar loss events in the US. There is indeed an acceleration in natural hazards that contributes to an increase in both the number and amount of claims related to extreme weather events.
Importantly, the increase in insurance premiums seems to be varying across regions, predominantly linked to areas prone to natural disasters. For instance, the state of Florida, highly exposed to floods and hurricanes, witnessed a 12.9% rise in insurance rates for multifamily properties, with the last five-year average loss ratios for homeowners' insurance standing at around 80%.
In California, where the exposure to wildfires is above average, insurance rates for multifamily properties have surged by 13%, peaking in 2017 with a loss ratio exceeding 200%. Worsening drought conditions have heightened the probability of fast-spreading wildfires. Additionally, losses in LA approached nearly $1 billion between 2009 and 2018. Consequently, insurers are strengthening their underwriting standards while increasing insurance rates. Notably, there has been a remarkable surge, of more than 240%, in new FAIR Plan policies between 2015 and 2020, reflecting the lack of coverage available in the private market.
But climate risk-induced rate hikes are not just confined to California and Florida. There are spillover effects in insurance rate for different states -- that less exposed states are paying increased premiums, just like the more exposed states. In an article by Oh, Sen and Tenekedjieva (2022), the authors find that insurers are cross-subsidizing insurance rates between states with less exposure and those with more exposure to climate shocks. This means that if climate-related losses occur in a region with stringent insurance regulations, preventing a proportional increase in insurance rates necessary to cover damages, insurers respond by raising rates in other regions with no climate exposure but fewer regulatory constraints.
Commercial real estate investors are struggling not only with increased insurance rates, but also to secure insurance that provides full coverage against climate-related events. This suggests that real estate investors and lenders are now facing additional risks that were previously mitigated by insurers, introducing a new channel of systemic risk in financial markets. Furthermore, these concerns extend beyond investors, as lenders are also apprehensive about the impact of rising insurance costs. They are particularly mindful of borrowers' ability to repay loans for properties in areas prone to natural disasters if a significant downturn in property cash flows occurs.
For investors, lenders, policymakers, and academics, many open questions remain. For example regarding the trajectory of insurance expenses for commercial real estate, particularly for multifamily investments. Are investors currently aware of the impact of rising insurance costs? Do commercial real estate operators consider the risk of natural disasters when assessing property risks? Is there a noticeable shift toward more forward-looking risk assessments? In the context of the commercial real estate sector addressing the increased frequency and severity of climate shocks, a critical examination of how key players are adapting and the strategies employed to adjust insurance pricing is quickly becoming an imperative – more research is needed to guide the sector in dealing with this new reality.
Oh, S., Sen, I., & Tenekedjieva, A. M. (2022). Pricing of climate risk insurance: Regulation and cross-subsidies. Available at SSRN 3762235.
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