According to the Council of Insurance Agents & Brokers, commercial property premiums jumped 10.1% in first-quarter 2024, representing the 26th consecutive quarter of increases.
While premiums for the commercial market have generally begun to stabilize, multifamily projects will continue to be hammered with hefty increases for the foreseeable future.
Commercial property owners and investors are eagerly seeking ways to reduce their insurance spend while obtaining adequate coverage to protect their assets and comply with lender covenants. That has led many to explore the concept of establishing a captive insurance company.
Captives allow commercial real estate owners to enhance protection, increase their self-insurance opportunities and customize their insurance coverage. In addition, they can benefit from underwriting profits that would normally go to their insurance carrier, further reducing their overall spend.
While captives are seeing growing acceptance for many coverages across numerous industries, the extraordinarily varied nature of real estate-specific risk makes captive evaluation increasingly nuanced.
Economic viability
The nature of captives generally makes them less feasible for organizations with less than $5 million in annual premium volume. While that may seem steep or unfair, it’s all about basic economic viability.
A captive needs to be sustainable from a loss perspective. With property risk, claims are considered “short tail” and thereby pay out more quickly, requiring sufficient premium volume to sustain the captive’s efficacy.
It is not unusual for an organization facing steep premiums to assume the captive strategy is the right answer, but moving to a captive isn’t like simply flipping a switch. The process involves the organization’s overall business strategy, financial strength and leadership’s appetite for risk.
An organization moving to a captive will be assuming a significantly larger share of financial risk. If a $50,000 deductible terrifies a CFO, they’re likely to be more alarmed by a captive in which they’re directly liable for half a million dollars or more.
Structuring a captive around any organization’s current situation is less viable than building it around foreseeable strategic goals. If real estate investors expect their portfolio to grow significantly, plan to divest a substantial chunk or shift into a new market or sector, their captive needs to reflect and accommodate those plans.
One of the most significant issues in the real estate arena involves the growing potential for catastrophic claims. If your portfolio includes properties in areas prone to flooding, wildfires or massive storms, your fast-growing premiums reflect insurance payouts for previous catastrophic events.
While some owners assume that refers only to coastal locations such as Florida and California, even inland states like Michigan are experiencing more large-scale wind-damage events.
Owners may be willing to assume the risk for catastrophic risks, but that doesn’t mean a carrier is going to share their enthusiasm for covering specific properties. Experienced captive consultants know which carriers are willing to find mutually agreeable solutions, even if that means stepping away from the captive approach.
Captive consultants can perform optimization studies that provide realistic projections for losses, informing recommendations for the most cost-effective way to structure the program. They can help real estate owners determine the optimal level of deductible based upon the expected rate of return on funds invested in the captive.
For example, suppose a portfolio has a low frequency of losses and the owners choose to assume and fund a million-dollar deductible. Based upon their expected rate of return, they’ll end up in a better financial position in five years than they would have had they chosen a lower deductible with a higher loss frequency.
Optimization studies can also consider the impact of structuring deductibles in a series of tiers. In addition to an overall deductible, there may be separate deductibles for earthquakes, flooding and so forth.
Rating and compliance considerations
One of the biggest obstacles to forming real estate captives involves meeting the requirements of third parties such as lenders. Loan documents often require specific coverage amounts and deductibles, while captives are typically designed to pair with high deductibles in the early years of operations.
Another common covenant involves the requirement that property be covered by a company with an A.M. Best rating, which provides a hurdle, as captives are not rated. Additionally, some commercial tenants have their own requirements for coverage. As an example, one major retailer requires at maximum a $250,000 general liability deductible with an A-minus or better rated carrier.
Captive professionals are familiar with multiple structures for addressing issues like these, whether it involves a comparatively simple indemnity agreement, structuring a captive in a fronted reinsurance program or renegotiating complex leases to allow a captive’s higher deductible.
One common risk transfer strategy when faced with a deductible restriction involves fronting, in which an insurance carrier will write a policy and cede most or all of the risks to a reinsurer, in this case a captive.
The carrier becomes known as the fronting company, receiving an agreed-upon percentage of the policy’s premium and paying out losses in accordance with the shared percentage. The downside of fronting is that it does include paying additional fees.
Another strategy some property owners use is developing a renter’s insurance program through which their lessees purchase insurance through the captive. The property owner earns premium income which helps to fund the captive, as few tenant claims are large.
Pursuing a captive is a change in business strategy that demands examining and funding risks in different ways. That’s why it’s important to consider your organization’s strategic goals, whether that includes growing, acquiring or divesting your property portfolio.
If an owner of multifamily developments currently owns 2,000 units but expects to grow to 8,000 in the next five years, their captive may need to be structured around that future level instead of today’s holdings. That may make the captive less attractive in the short term, but as the owner moves closer to that growth goal, the benefits of the strategy will become increasingly evident.
Captives are intricate structures, requiring professional planning, forecasting and advice to achieve long-term success. Choosing an experienced captive advisor or manager gives investors and other owners access to knowledge about captive types, ownership and program structure, service provider guidance and working relationships with carriers and other key players.