Why Are There Property Insurance Availability Crises in FL, TX, CO, and CA?

What you will get from this article:

🏠	What is the purpose of property insurance?
🏠	What happens when an unexpected natural disaster affects thousands of policyholders in one state?
🏠	Why primary insurance companies also buy insurance - and what it's called
🏠	How do reinsurance companies manage their big risks - and how does this affect individual policy prices?

In the past few months, I’ve seen some news stories about people either being canceled by their insurance company or experiencing enormous increases in their premiums despite never having made a claim. It’s fair to ask, “What the heck is going on here?!” I hope I can answer that in a way that will not only be illuminating but also helps you make decisions as rental property owners.

What is the purpose of property insurance?

As I’ve discussed in the past [How Much of a Property Deductible Should You Carry?], the purpose of insurance is to transfer a financial risk that is so large that our lives would be affected if we had to pay it on our own. As property owners, there is the obvious risk that our property will be destroyed. In addition to tremendous inconvenience (even if you weren’t living in the property at the time), such a loss would be a devastating financial blow to most people.

Insurance allows us to pay a small percentage of the house’s value each year and, in return, a large financial institution will pay to rebuild and for our living expenses while it’s rebuilt.

While having to rebuild an individual home would be a significant blow to its owner, it happens multiple times per day to an insurance company. Insurers can pay for these without blinking because they can figure out how often houses are damaged and how much they will cost to rebuild, and hence how much they need to charge for their premiums.

Although they can’t say which of the houses they insure will be damaged, they can predict how much they will pay in total over the next year. (The prediction won’t be perfect, of course – insurance companies are run by humans, after all – but they are usually close enough that the insurer’s shareholders and potential shareholders can use them to make their decisions.)

Insurance companies buy insurance, too

But even insurance companies need to buy insurance sometimes! You might reasonably ask why they would do that, and the answer is the same as the reason individuals buy insurance – to transfer a financial risk that is so large that the insurer’s “life” would be affected if it had to pay it on its own.

Example: FL Homeowners Insurance Company

The easiest way to see this is an example:

Let’s say you are a homeowners’ insurer, and you have ten thousand policies on homes in Florida (that would make you a small insurer – large H/O insurers have hundreds of thousands of policies in Florida at any one time.) The premiums you collect on those homes are undoubtedly sufficient to pay if, say, one of your insured homes was destroyed on every day of the year, and it wouldn’t even raise an eyebrow when you came to report your results for the year. Your shareholders will be perfectly fine, and you would continue doing business.

This is not to say that the people who work for insurance companies are indifferent to the plight of the people whose homes were destroyed. Of course they are sad for the people, and they help them to rebuild their lives by paying out claims according to policy terms.

What happens when there’s a natural disaster that affects thousands of policyholders?

But now let’s say a hurricane blows through and destroys two thousand of those homes? Lots of things are going to happen as a result, and all of them are bad:

The cost to rebuild each home is going to skyrocket! This is called “demand surge”, and you can see why it happens; local building suppliers have enough stock on hand to cover regular volumes of business, not rebuilding thousands of houses all at once. And the number of contractors in the area is not enough to rebuild thousands of houses at once, and there aren’t enough available empty houses or apartments to house everyone who has been displaced, etc. Obviously, the suppliers will order more materials, and contractors will come from other states, but basic economics says that costs will be higher.

You undoubtedly don’t have enough local adjusters to handle all of the claims that are coming in; you have enough to handle the normal number of claims. You can bring adjusters in from other offices, or course, and there are independent adjusters, but those will be extra costs, and they don’t necessarily know the conditions that are unique to Florida.

You’re going to have to tell your shareholders. While it’s not your fault that a hurricane came through, they aren’t going to be happy with you. If you don’t get a bonus this year, that would be a pretty mild outcome. In the worst case, your company will have lost so much money that it can’t meet the required capital ratios and has to go out of business.

The above shows that there can be events whose financial significance is so large that even an insurance company can’t pay it without significantly disrupting its “life."

So, insurance companies buy reinsurance

To remedy this, property insurers buy what is called “reinsurance” – they buy insurance from someone else to cover events like hurricanes, firestorms, earthquakes, etc. Probably the most famous “reinsurer” is Lloyds of London.

Reinsurance companies can be likened to insurance companies for insurance companies, but they are even more highly concentrated because they don’t have a big network of agents to sell their products to hundreds of millions of consumers, and don’t need to have a big set of adjusters. Instead, there are a few thousand “consumers” that come to them, and the reinsurance adjusters just review the work of their “customer’s” adjusters. This concentration explains why so many reinsurance companies can be located in tax havens – they have relatively few employees who can do much of their work by phone and computer.

This concentration extends to capital, too; reinsurance companies need a lot of capital to prove to their customers and regulators that they will be able to pay when losses occur.

How do reinsurance companies manage their big risks?

Of course, you can reasonably ask how Lloyds is big enough to reinsure the biggest events, like if a hurricane were to hit Miami, or a wildfire hit Los Angeles. There are a few answers:

Property reinsurance is typically syndicated, meaning that each reinsurer may take only a small percentage of a reinsurance deal, so a single deal won’t overly affect the reinsurer’s overall results. This helps but is not a panacea because a hurricane will hit every company that does business in that area, and the reinsurer may reinsure several of those.
Reinsurers can buy reinsurance, called “retro” to spread the risk. This also helps some, but the retro reinsurers have the same issue as in 1); multiple companies they reinsure will be hit by natural disaster.
Catastrophe bonds allow insurers and reinsurers to securitize their risk. These bonds pay above market rates (which the reinsurers can afford to pay if it’s a good year) but lose principal if it’s a bad year.

Predicting the cost of catastrophes

We need one more piece of the puzzle before we can see what’s going on in homeowner’s insurance, and that is catastrophe modeling. This part of the business allows insurers and reinsurers to monitor their aggregate exposure to a catastrophe, and there are a number of companies that have developed extensive models to project how much their clients will pay in a particular type of catastrophe.

This is important because catastrophes happen rarely, so, while our Florida insurer could give a pretty good estimate of the average dollars they will pay each day in “regular” losses, a hurricane that destroys 2000 homes may only happen once every 25 years, and when that does happen the costs will be more than 2000 times the cost for a regular house (as we’ve discussed above.)

Property reinsurers have been losing money

So now, with all that background, we can see what’s going on with homeowner’s (and landlord) insurance:

The last few years have been bad ones for property reinsurers; they have lost money. And when you lose money in the reinsurance business, you generally lose a lot of it. While the shareholders in reinsurance companies understand that the company results will vary more than a normal insurance company, their patience is finite.

Similarly, the executives in the reinsurance business know that the company results will vary so that (let’s get down to brass tacks), they will get outsized bonuses some years and zero bonus in others, but after bad years they have to show their shareholders they are doing something about it.

Exit property reinsurance

In the case of property reinsurance, the quickest, surest way a reinsurance executive can show they are “doing something” is to say, “we’re getting out of the property business.”

While closing a business is painful, remember that reinsurance companies are relatively small in terms of staff so that, while no one takes layoffs lightly, there are relatively few, and there won’t be empty buildings left standing around the country.

Downsize reinsurance exposure to highest risks

If they don’t want to get out of the business entirely, they can also say, “we’re going to reduce our exposure to Florida hurricane.” This usually means that they’ll cancel some of their reinsurance contracts, or they will reduce their “share” of Florida contracts. (Remember that property reinsurance is typically syndicated, so if you want to reduce your exposure, you can just reduce your share when the contract comes up for renewal.)

The losses from recent years have caused many reinsurers to cut back on their shares, or quit property reinsurance entirely. While this might seem like collusion, the reinsurers don’t need to collude; their clients will ask them to take a larger share to the contract to make up for the reinsurers who have left, so even if a reinsurer is completely asleep at the button, it will be forced to see what’s going on.

Increase reinsurance rates

Another reaction has been to increase the rates the reinsurers charge, and the increases have been significant. This is normal business (even if you are still asleep at the button); if a customer asks for more, you raise your price. Those companies who aren’t asleep at the button will ask for large increases, both because they want to show their shareholders that there’s a good reason to keep writing property insurance, and because of the natural action of supply and demand – when supply shrinks, price goes up.

A further reason for the price increases comes from modeling; the past ten years have seen an inordinate amount of “once in fifty year” events. This means that the amount that reinsurers expect to pay about once every fifty years has happened several times in the past ten years! When this happens, you have to reconsider your models, and one aspect that insurers, reinsurers, stockholders, regulators, and modelers have had to consider is whether we have just had bad luck, or whether something systemic is going on.

If you believe that something systemic is going on, then a very likely suggestion is “global warming” and the models that predict the globe is warming also predict increases in the frequency of hurricanes and wildfires are predictable outcomes.

My experience in the insurance industry is that there is a variety of opinions about global warming (just as in the rest of the population), but the people who don’t believe in global warming recognize that they have a duty to their company and their clients to contemplate and plan for its possibility.

Modeling companies have a similar calculation; they may not believe in global warming, but their customers demand that their models contemplate the possibility that the globe is warming. This causes the modeled frequency and severity of catastrophes to increase.

A perfect storm leads to rising insurance rates

All of this answers the question as to why property insurance rates are going up and may be hard to find in some areas; some reinsurers have left the business, or reduced their exposure, meaning supply has gone down. Those reinsurers still in the business are demanding higher rates, which causes their clients to pass on those higher costs. Some insurers have also stopped accepting new business in some areas, as seen in California where State Farm and Allstate (among others) have pulled back.

Reinsurance has traditionally been a cyclical business; reinsurers pull back after a big event, leading to a few years of higher rates, but eventually new reinsurers are formed which brings prices down. The extent to which this happens this time around is yet to be seen.

What do reinsurance rates mean to real estate investors?

So what does all this mean to us as property investors? Well it means that we’ll probably see higher insurance rates, even if we’re not in the highest exposure zones. While any increase comes out of our bottom line, the cost increase will probably be manageable in many areas.

If your property is in a coastal area, or in a wildfire zone, you probably need to plan for larger increases. If you are considering buying a new property, then you should probably give more consideration to insurance cost and availability when decided what property to buy.

Here is a link to a map created by FEMA that shows FEMA’s estimates of different risks in different counties.

https://hazards.fema.gov/nri/map#

While insurance cost and availability is just one consideration when purchasing a property (whether for investment or to live in), I hope this article helps you to understand what has caused insurance issues in some areas, and this helps you to determine which is the best property for you.

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