Author: Caley LaRue
After all of the unexpected changes in 2020, it seems everyone should retire their crystal ball. No one could have anticipated a global pandemic, yet commercial real estate (CRE) is doing its best to find a path through. Real estate professionals know cycles come and go, yet this cycle is really packing an unprecedented punch. The impact of COVID-19 on each individual asset class was not universal, and the expectation is that the insurance market will remain as such until the end of 2021. Single family, industrial and data warehouses performed above expectations, while indoor malls and hospitality were hit disproportionately harder. Office and multifamily were situational, depending on tenants and liquidity.
The phrase "cash is king" may never have rung louder. Short- and long-term debt liquidity as well as debt maturity schedules quickly came into focus for asset managers and Directors & Officers liability (D&O) insurance underwriters. Providing proof of liquidity and balance sheet flexibility became critical for insurance renewals. The goal was to retain the same limits while minimizing increases in premium and retention.
Litigation, defaults, bankruptcy for insurance renewals
The biggest factors impacting insurance renewals is the real or perceived threat of these three words. Net asset value (NAV) decline is one of the largest drivers of litigation, and even frivolous litigation requires defense. D&O insurance underwriters are trained to avoid risks with poor liquidity/high bankruptcy likelihood or ones that are heavily leveraged. In a global pandemic, it became very hard to delineate good risks from bad. The result was less competition by underwriters, rejection of new business and a cynical eye toward even the most well-capitalized clients.
Good risk management continues to focus on making sure even the best deals are papered up with solid contracts, and insurance needs to be one of those contracts getting attention. We know from past cycles that litigation, even frivolous suits, will need to be defended. And just as material costs go up with demand and inflation, so do attorney hourly rates for the highest-quality lawyers for such defense. The time is right to reevaluate any potential areas of concern for investor litigation and to bolster risk management around that, especially so given where we are today.
We have been noticing of late that certain real estate sectors are getting a deeper review by the insurance underwriters. Whereas in the past, the good results for insurance companies' professional real estate risk was more uniform and not specific to segments, we have seen that change more in the last 12–18 months. Hospitality and malls have the most difficult renewals in the market. The next most challenging are multifamily, to the extent they are impacted with rent moratoriums and dependent on debt. The most favorable renewals are single-family homes, data and industrial.
The insurance market looks at the real estate fundamentals of occupancy rates, debt and maturity schedules. This has to be well communicated, and it is important to try and project cash flow scenarios out for the next 12 months. Real estate risks were historically deemed a favorable class compared with "high-hazard" classes (e.g., tech or pharma risks) as insurance companies look to choose where they deploy their capital. This has changed as the pandemic created disruption in the insurance market, and as insurance underwriters try to see into the future to sort who they perceive will be the winners and losers in the coming year.
Underwriter profitability has been spotty, and overall most are not making money on their executive lines risks (D&O and E&O) books of business; thus corrective action has been their focus. While clients who purchase D&O generally focus on premium, underwriters actually focus first on how much limit (capacity) they are willing to risk on any one risk. The second area they focus on is the deductible/self-insured retention, and increasing those to be higher. Once they feel they have the limit/retention sorted, they then turn to the rate or premium. Because of poor historical underwriting profitably, we have sadly seen capacity reduction, increases in retention and premium increase — even on clients who have no losses. Underwriters are looking to push premium/rate up on even their most desired real estate accounts, and more aggressive increases on risks they deem tougher or ones that have had poor claim experience. Some accounts are even deemed so undesirable, they cannot get limits for any price — although that is rare.
The past concern of merger and acquisition (M&A) litigation seems to be declining, although underwriters are still holding to higher M&A self-insured retentions on their policies. M&A retentions usually scale up depending on the total market cap or assets under management, and range from $500,000 to $1.5 million. In addition to M&A claims, underwriters are attentive to joint venture (JV)/limited partner litigation, especially as JVs unwind. Tender offer or roll-up of minority interests will always be a concern; expect questions from underwriters, as this has been a highly litigated area. As far as emerging trends, underwriters are extremely concerned about initial public offerings (IPOs)/special-purpose acquisition companies (SPACs), and these are now viewed as a very hazardous risk. IPO risks are in the hardest market at the moment.
The insurance market for CRE is divided into a few subcategories that are experiencing different trends as noted.
Publically traded equity real estate investment trusts (REITs)
Historically, CRE D&O was priced at a ~25% discount to similarly sized market cap companies, as CRE D&O risks are less volatile. Wild swings in market cap that attract a professional plaintiff's bar were less likely, and that was reflected in the premium. As underwriters become unprofitable across their entire books, REITs looked underpriced and became the nail sticking up to be pounded down. Rates have been increasing on primary polices from 30% to 70% based upon historical pricing and risk assessment. The excess D&O market for REITs had historically been more competitive than primary layers, but that too has reversed, and excess carriers are seeking even bigger premium percentage increases than primary, as the losses have hit their layers and they are looking to correct historically low premiums. Overall premium increases have ranged from 25% to more than 150% depending on asset class, debt levels and the impact of COVID-19.
Public non-traded REITs
This class has historically had less capacity than traded REITS due to underwriters' perceived issue around valuations and roll-up/exit strategies, as well as internalization of the managers. Improving transparency around corporate governance is really getting noticed by the D&O underwriting community, and that is starting to bring in more capacity. The insurance market capacity in general is much reduced for this class of business compared to public REITs, and premium rates and retentions are frequently higher than public REITs. Premium increases have averaged around 25%–50%, with larger increases in certain asset classes, similar to what is seen in publicly traded equity REITs.
Privately held companies
Private companies and private REITs are deemed to be the most favorable, and capacity is generally readily available for this class. Coverage needs to be reviewed very carefully, as these policies have standard exclusions that need to be modified for real estate accounts. If left unmodified or not endorsed properly, significant coverage gaps can occur. Of all of the policies we review, the most holes or gaps in coverage happen in this space. One of the top areas underwriters are seeing losses is in fundless structure driven by real estate companies that didn't require audited financials for the individual LLC. Premiums and retentions in this space are more stable, but we are seeing upward pressure due to overall loss experience of D&O underwriters' other lines of business, and would plan for 15%–30% premium increases.
Please note, a client's risk profile is the primary variable dictating renewal outcomes. Loss experience, industry, location and individual account nuances will also have a significant impact on these renewals. Now more than ever, it's important to start renewals as soon as possible, and work with your Gallagher team to deliver a comprehensive and professional submission to underwriters.