This market alert is from May 2023.

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In a Turbulent Market, Property Insurance Due Diligence Is Key for Private Equity Investors

The currently difficult property insurance market — one of the hardest in decades — is challenging even the most seasoned insurance brokers. It also has potentially profound implications for private equity investors targeting the commercial real estate sector or companies that rely on office, industrial, retail, or multipurpose facilities.

The recent upheaval in the property insurance market has been due to several factors, including:

• Persistent high inflation over the past 12 months that has not been seen since the 1980s;

• Widespread supply chain issues caused by a variety of geopolitical events;

• More frequent and severe weather events;

• Remote/hybrid work, which is affecting business income figures and overall valuations for property owners;

• Rising material costs paired with labor shortages;

• A disconnect between values reported and actual losses; and

• Withdrawal and repricing of reinsurance capacity.

A changing market

To appreciate how much the market has shifted over the last five years, imagine a commercial property located in Jacksonville, FL. In this hypothetical example, the property has significant coastal windstorm exposure, is not located in a FEMA flood zone, and was built in 2010 using up-to-date wind resistive construction methods. The following table illustrates how the property insurance program structure would likely change, and the premium would increase 200% to 500%, in just five years.

The impact on due diligence

It is widely accepted that the insurance market can offer private equity investors a variety of solutions if coverage gaps involving target companies are identified during due diligence. As a result, insurance due diligence can sometimes be relegated to the confirmatory stage. Unfortunately, this will no longer lead to an optimal outcome.

In addition to challenging market conditions and reduced capacity, property underwriters are also being inundated with submissions. The result is a marketplace that can struggle to respond when solutions are needed in “deal time.”

To provide a meaningful review of the property program, it is important to allow adequate time to assess, price and place property risk. Failure to do so could lead to reduced coverage, more restrictive terms, and significantly higher costs.

Areas of focus

Today’s market requires a different approach to property insurance. The following should be areas of focus during due diligence process:

• Property policy renewal date relative to the close date: If the policy renewed recently, it is important to understand what changed at renewal. Were values restated? How were values determined? Did terms and conditions change? Did the target decide to purchase less coverage? Did the insurer have building engineering concerns? If the policy renews in the next six months, similar questions should be asked to assess the target’s insurability and the potential impact at renewal.

• Timing: The “war on talent” has had a profound impact on insurers. Many underwriting positions have become a virtual revolving door. The net result has been significant market dislocation, with line underwriters having less discretionary authority and deals taking longer to complete. Beyond this, insurers are demanding greater detail and more exhaustive modeling.

• Availability of coverage: In the not-so-distant past, just about any property enhancement could be obtained for a price. Sadly, this is no longer the case. It is important to enter investments knowing that some critical coverages might not be available in the near term. This is particularly important with considering targets with properties in areas exposed to flooding, wind, earthquakes, and other catastrophes.

• Lender requirements: Insurance requirements imposed by lenders are often disconnected from the realities of the marketplace, but failure to comply can lead to a breach of contract. It is important to determine early on if any imposed requirements can be realistically executed, and to work with lenders to modify them as needed.

• Replacement cost calculation: The adequacy of building valuations has become one of the single biggest points of contention with insurers. Escalating material and labor costs have led to losses that far exceed reported values, and the market has pushed back sharply. Due diligence efforts should assess the accuracy of values, offer the resources necessary to ensure they are reflective of current replacement costs and provide ongoing support for market negotiations.

• Business interruption values: Underwriters will expect that a business interruption worksheet be completed for key locations. Contemplating the loss of a location for 12 months, the lost net revenue, and continuing expenses is the baseline for these calculations.

• Cost: In past hard market cycles, challenging conditions tended to be isolated to certain industries or geographic locations. Today’s market, however, does not discriminate. Even the best risks can see increases of 10% to 35% at renewal. Those that are CAT-exposed or have had claims can expect increases from 50% to 125%. As a result, property insurance premium could impact EBITDA in a meaningful way.

How long will this market cycle last?

In the past, when market conditions hardened, new entrants typically emerged to capitalize on higher rates. This fresh capital inevitably brought pricing back in line.

Unfortunately, the breadth of the current market challenges makes this an unlikely scenario any time soon.If anything, conditions are worsening as CAT and attritional losses continue to rise, capital becomes more expensive, and insurers struggle to adapt their terms and pricing.

Harnessing the power of your portfolio

For private equity investors, there has never been a better time to harness the combined buying power of their portfolios. Insurers now have entire teams focused on private equity, charged with developing custom solutions on an individual or aggregate basis.

In many cases, presenting multiple companies to the market at the same time can generate interest where there previously was none. Although expense reduction is one of the obvious goals of a group purchasing strategy, given present market conditions, it might be the difference between getting coverage or not.

How Lockton can help

Private equity investors can more effectively take these steps by choosing the right risk advisor. Lockton’s team of experienced insurance brokers can work with portfolio company management and private equity investors to determine how to best structure property insurance programs to suit their needs and budget.

Among other items, Lockton can advise private equity investors on:

• Various insurance program possibilities, including buying less limit, taking higher retentions (deductibles), or quota sharing certain layers.;

• CAT modeling, which has become more important to underwriters;

• Investments in risk mitigation that are favored by insurers; and

• A variety of nontraditional program structures, including captives, deductible buydowns, and parametric products.

Private equity firms should recognize that property market conditions have shifted profoundly with implications for cost and even deal viability. It is important to address property insurance early in the due diligence cycle and ensure that potential costs and options are well understood. It is also critical to allow more time to ensure an optimal outcome.

For more on this topic or how Lockton can help, contact a member of your Lockton team.