The recent earthquakes in Mexico, Hurricanes Irma and Harvey and the shooting in Las Vegas highlight the major impact disasters can wreak on properties. The damage to property pales in comparison to the human loss and injury, but it highlights the need for preparation to help mitigate the risk, recover from the damage and perhaps save lives.
Lenders require owners of assets to get property insurance coverage that provides for replacement cost for damage caused by disasters. It is natural for lenders to demand the assets in which they invest to be insured to protect their investment, and they’ve always required it. Yet, there is more attention being paid to natural and manmade disasters these days and lenders tend to respond to disasters with stricter requirements.
It is hard for lenders not to do so when taking into consideration the millions of dollars of damage. Lenders may not require hurricane insurance for an asset in the Inland Empire, but they will require earthquake insurance if the property is in a location where earthquakes pose real risk.
To gain a better perspective on property disaster insurance trends, we asked two experts in CRE insurance to share insights. This included Arthur J. Gallagher & Co.’s Alex Glickman, Area Vice Chairman, Director-Practice Leader, Real Estate & Hospitality Practice, and Aon Risk Services’ Jason S. Peery, Resident Managing Director, Senior Vice President.
Q: Who is impacted by earthquake insurance requirements?
A Glickman: All asset classes, particularly industrial flex who tend to be concrete tilt up and most vulnerable to seismic activity. Retrofitting to improve the structural resilience can be expensive, but given the fact that standard earthquake deductibles are 5% of the replacement cost of the asset, it’s actually in the owner’s best interest to retrofit. It also serves to protect those people who work in the assets who could be injured due to a collapse.
Q: What is required?
A Glickman: Earthquake insurance is required by lenders to protect their mortgages and in the recent past, lenders have become more conservative. Many, if not most, require that a borrower purchase earthquake (EQ) insurance if the “Probable Maximum Loss” (PML expected damage in an earthquake) is 20% of the replacement cost (cost to rebuild not Fair Market Value). Furthermore, if an owner has multiple assets that are all subject to the same earthquake, lenders are now requiring that the earthquake limits that are purchased on the portfolio are sufficient to protect all the damaged asset. This is leading to higher requirements for EQ limits.
Q: Where is this taking place?
A Glickman: California, the Pacific Northwest, and The New Madrid States (Tennessee River Valley). Additionally, flex assets are subject to higher rates of hail and wind damage due to their design.
Q: When did lenders start tightening their requirements?
A Glickman: In the past 12 to 18 months, we’ve seen stricter requirements, particularly from CMBS and securitized lenders. The recent hurricanes and floods have also made lenders more concerned and conservative.
Q: Why do companies purchase EQ and at what cost?
A Glickman: Earthquake insurance premiums are a function of the construction class, retrofitting and overall maintenance of an asset. Not only do lenders require earthquake insurance, but prudent owners purchase it to protect cash flow and have proceeds to rebuild their assets. Earthquake premiums will also differ based on the size of the portfolio and the amount of limits purchased.
Q: What are some of the new considerations surrounding disaster insurance?
A Peery: It is important to insure a portfolio as a portfolio rather than just doing a probable maximum loss (PML) for one asset. If you do per asset you don’t account for how it might impact the whole portfolio and wind up insuring for too much. Once you see how a portfolio might respond to various earthquake events, you can see the data and know what to expect. That can be used to negotiate with lenders and not take their requirement at face value, but challenge them, so that an owner buys the appropriate amount of coverage and still satisfy the lending requirement.
Q: What is the benefit of performing modeling?
A Peery: Conducting modeling to see how a portfolio performs under certain earthquake scenarios can give an owner or asset manager a feel for the losses that might be incurred, and appropriate insurance limits to purchase. That allows them to present a case to lenders to set the appropriate amount of coverage, in the event that their requirements are too stringent. Sophisticated modeling over time helps determine what’s adequate and that’s evolved.
Q: How does modeling help save money?
A Peery: Some portfolio managers and owners have been insuring assets based on PML for one building. It is a common practice in the CRE industry to have one PML per building without looking at the overall. Owners typically buy by the building and don’t consider the entire geography of the entire portfolio. But an aggregated modeling can set appropriate limits and reduce the chance of overspending by getting a real life view for the whole portfolio. For some portfolio owners it can save them millions by not doing one-off insurance deals, by building.
Estimates from the California Earthquake Authority’s Uniform California Earthquake Rupture Forecast predict a more than a 99% chance in the next 30 years that a magnitude 6.7 earthquake or greater will hit somewhere in California. Terror events are becoming more common occurrences. Given all those considerations, it is wise to remember that no place is immune or safe from natural or manmade disasters. Properties that prepare for such events by securing the proper amount of insurance coverage will help reduce their risk of damage and loss.