Advice
Business owners and managers are risk-takers. Many are accustomed to dealing with speculative risk which offers three potential outcomes: a loss, no loss, or a gain. However, Traditional Risk Management or Commercial Insurance, works with pure risk, which is the chance of loss or no loss. For example, on any given day, a building could suffer a fire, or it could have no fire. A guest could slip and fall on the grounds or visit the facility without a fall.
There are several ways to treat pure risk including Risk Elimination, Risk Reduction, or Risk Transfer. The first two methods are self-explanatory, but Risk Transfer occurs when you transfer risk to another party. Risk Transfer can be achieved within a lease or a construction contract, but it is most often performed by purchasing an insurance policy from an insurance carrier in exchange for a small premium relative to the risk being transferred.
The amount of the premium a business pays for this risk transfer is dependent on market conditions which are made up of economic indicators, as well as weather events. Market conditions are cyclical in nature, moving from hard to soft markets regularly. Currently, we are experiencing a hard market which has led to a rise in premium rates.
How Commercial Insurance Works
Insurance works through the Law of Large Numbers, which states that losses become more predictable as the pool of policyholders grows. An insurance company will group a large number of insureds with similar risk profiles, then use the aggregation of premiums to pay the losses that occur.
Insurance companies are in business to earn a profit. This happens when premiums earned exceed the sum of losses, loss adjustment costs, and expenses. The industry uses the combined ratio to determine profitability of an insurance company and it is calculated by adding the loss ratio and expense ratio. Think of a premium dollar as a pie. The total losses and loss adjustment costs are one piece of the pie. The total expenses are a second piece of the pie. The remaining pie is profit. The ratio does not include investment returns, so a carrier with a combined ratio of 100% could still earn a profit through investment returns on their reserves, but the higher the combined ratio, the less likelihood of a profit.
Insurance companies insure a variety of risks for businesses with policies being the contract between the insured business and the insurance carrier. Claims can generally be lumped into two categories, 1st party (the insured business), and 3rd party. A 3rd party claim is a liability claim where a 3rd party was injured by the insured. These claims are usually triggered by a demand, or a lawsuit, and suits can take years to work through the court system. As such, liability claims typically pay out over an extended period, leaving the carrier with options for investing reserves. On the other hand, 1st party claims involve direct loss to the insured and are often paid out very quickly as the property is replaced or rebuilt.
Property claims, especially those resulting from weather, can often affect many insureds of the same carrier. Because of this and the shortened payout timing, insurance carriers will buy reinsurance to cap their losses in a given year. Reinsurance is insurance for the insurance carrier that could be structured to limit losses from multiple policies in a class of business (Treaty Reinsurance) or on specific accounts (Facultative Reinsurance). For many decades, the reinsurance industry was generally very profitable. With low interest rates for many years, reinsurance companies provided an investment opportunity offering attractive returns with moderate to low risk. Because capital was easy to attract, capacity was plentiful.
In 2022, the reinsurance industry swung to underwriting losses, in part due to Hurricane Ian which was the third-costliest weather disaster on record with over $100 billion in damage. Ian hit a section of Florida coast that had not seen a major storm in over 50 years, so most buildings were not built to more recent hurricane standards. Reinsurance underwriting losses, coupled with higher interest rates, have caused capital to flee the reinsurance industry for safer returns elsewhere. The result is a reduction in capacity for coverage and a restriction on what is covered.
The year 2023 is the costliest year on record for severe convective storms with insured losses surpassing $50 Billion by September. The U.S. Midwest did not escape this increased storm activity, seeing a dramatic increase in wind and hail events. Additionally, increased inflation, staffing shortages, and supply chain issues have led to higher costs for reconstruction of damaged buildings. The unprecedented rise in weather events and ongoing economic factors are straining carrier balance sheets, and by extension is affecting reinsurance carriers negatively.
What does all this mean for Property Insurance?
The insurance industry generally defines market cycles as hard, soft, or flat. A soft market consists of declining insurance rates while a hard market cycle is defined by increasing insurance rates. The current property insurance market is experiencing a swift hardening. This is manifesting itself in increased property rates for insureds, increased reinsurance rates for carriers, reduced capacity, and higher retentions.
Insurance carriers are seeing reinsurance costs increase while retentions, the amount of risk they keep on their balance sheets, are increasing. New reinsurance treaties are also reducing capacity by eliminating entire classes of business from consideration or limiting the total insured value at any single location. Classes that are seeing reduced capacity are habitational occupancies, hotels and motels, and commercial tenant-occupied buildings. Additionally, many insurance carrier’s combined ratios are well above one hundred, some as high as 150, indicating a profitability and sustainability outlook that is downright bleak without action.
In this environment, most insureds are likely to see an increase in their property rates, while also being pushed to evaluate their building limits to ensure they factor in recent inflation. They may also be required to take higher deductibles or see specific deductibles for wind and hail. Certain classes of business will face tougher underwriting scrutiny for their property insurance or find it more difficult to just place property insurance.
It is important to note that this is a cycle in the market that has happened several times in modern history. Economic indicators play a role in a hard market, but weather patterns are contributing factors this time as well. While things could get worse before improving, history teaches us that hard markets do not last forever.
If you have questions about your property insurance, now is a great time to reach out to your agent and discuss options for weathering this hard market.
Insurance products and annuities are not insured by the FDIC or by any other government agency, are not deposits or obligations of, or guaranteed by 1st Source Bank, and may involve investment risk, including loss of value.