The Factors Driving Rental Property Insurance Underwriting Decisions
Creative Solutions are Needed to Serve Real Estate Investors By Scott Phillips It seems you cannot go a day without hearing about the ongoing economic inflation that has been ushered in on the heels of the global pandemic. There seems to be no aspect of life unaffected by inflation, including rental property insurance. But why? What are the factors that are truly driving rental property insurance underwriting decisions? Hopefully, the following will answer those questions in a concise and digestible format. Underwriting a rental property insurance policy can be boiled down to two core factors: The risk exposure of a given property or portfolio of properties and the cost to replace the property(s) in the event of a loss. The risk exposure of a property is the primary driver of both property and liability rates. But first, what is an insurance rate? An insurance rate is a simple metric of cost per $100 of insurance coverage. » Rate x per $100 of building coverage = Premium » $.50 (Rate) x 2,500 ($250,000 (building coverage)/$100) = $1,250 (Premium) Through the lens of an underwriter, determining the condition and inherent risk of insuring a property’s structure and liability exposure is an incredibly complex multi-faceted equation. The risk exposure of a rental property is determined by three factors: »Geographical Location // Exposure to natural disasters, weather, and crime. »Property Condition // Age, construction quality, type, and updates/upgrades. »Property Management // Occupancy, tenant screening, maintenance, etc. With the amount of accessible data these days, it has rendered the exposure to CAT activity, i.e., catastrophic weather events in the area where the property is located, as the biggest variable risk factor to determine. According to a recent report released by AON, after adjusting for inflation, in 2011 the number of CAT events costing $1B+ was 10, in 2021 it had jumped to over 22. In 2022, the total economic impact of natural disasters was estimated to be $313B globally. It is important to note that most of the costs behind these large numbers are NOT for total losses but rather partial losses, such as when a part of a roof blows off during a major weather event and rain destroys a portion of the home but leaves the structure intact. Ultimately, the anticipated frequency, severity, and cost of claims within a given area drives the rate an underwriter needs to obtain to achieve a sustainable loss ratio. Since rental properties exist across the United States, the real estate investor insurance market is frequency driven vs. severity driven. Accordingly, the cost to repair a partially damaged home such as in the above example, is more expensive per square foot than it is to (re)build a new home. The data supporting this is widely accessible but anecdotally anyone who has remodeled their house can attest to this. This calculation is known as Insurance to Value (“ITV”). ITVs are based off either Replacement Cost Valuation (“RCV”) or Actual Cost Valuation (“ACV”). It is very important to distinguish between RCV and ACV. RCV is the cost to replace the damaged part of the home today while ACV is what the current value is less depreciation. For reference, to replace the roof in the above example could cost $10K, but if it was insured as ACV, it may only be worth $1k because it was near the end of its predetermined life expectancy of say 25 years, thus resulting in two very different outcomes for an investor and overall claims experience. Since ACV is more of a calculation determined by depreciation and not the actual cost of labor and materials in today’s prices, we will only focus on RCV factors and drivers. Claims data from the past nine months as of February 2023 from our data partners at Verisk 360Value®, reported a nationwide average replacement cost for a typical rental is $181/ft. The bands of the report were from $155/ft (AR) to $232/ft (AK/HI). Meaning, on average a rental property should be insured at: $181/ft (RCV) x 1,500 Sq Ft home = $271,500 Dwelling coverage (100% ITV) As you can see, pulling back on the RCV per square foot will lead to underinsuring the property. Historically and understandably, the REI industry has been widely underinsured, with estimates below 50% of the recommended ITV. However, the causes of the underinsured estimates are NOT a straight-line to investors trying to control costs and stabilize cashflows, but rather a combination of factors, most notably inflation that has driven up the cost of capital, labor, and materials. In addition, the rapidly increasing frequency and severity of catastrophic weather events throughout the US has profoundly impacted the entire insurance ecosystem – a topic that far exceeds the depth in which this article is intended to cover. The growing challenge of balancing the financial constraints for a rental property to be a viable investment with the need to properly insure the property has become exponentially more difficult. This challenge has forced underwriters and brokers to produce creative solutions to continue to serve their investor clients. Meanwhile, real estate investors of all sizes are feeling as though they need to take a crash course in risk management to better navigate these solutions. Investors navigating their own risk management strategies can look to do the following: » Be sure to work with a broker with expertise in this niche property insurance market, including access to specialty insurance markets solely focused on the REI industry. » Be diligent with the maintenance of the property to prevent avoidable losses in the future. » Consider working with/hiring a property manager that offers: • Preventative maintenance programs – including 24/7 resident incident reporting. • Thorough tenant screening protocols and regular property inspections. • A property insurance program. There is no ‘silver bullet’ for real estate investors to thwart or eliminate the higher cost of property and liability insurance for their investment properties. However, there is some good news. Recent data shows the cost of materials is coming down as supply issues
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