How banks can plan for commercial property insurance costs

Recent trends influencing property insurance costs include:

• Weather-related catastrophes. The past decade has seen an upward trend in the frequency and severity of destructive weather-related incidents including storms, hurricanes, and wildfires. Damages and future concerns have especially risen in coastal areas.
• Replacement costs. An increase in materials and equipment costs combined with a shortage of skilled labor have led to more expensive rebuilding projects.
• Fraud. Bad actors who file fraudulent damage claims have also contributed to increased property insurance costs.
• Re-insurer challenges. Smaller insurance companies that often provide coverage in markets where larger insurers choose not to compete have been more selective themselves due to rising re-insurance costs. The lack of cost-effective re-insurance options for these insurers leads to even less competition and even higher insurance premiums in those markets.

The dynamic nature of these factors can lead to significant changes in insurance premiums over time. Property insurance costs from just one year ago might no longer be suitable for a bank to use when assessing a borrower’s current repayment capacity.

Additionally, borrowers who let their insurance coverage lapse due to rising costs can quickly turn what was once considered a stable loan into a problem loan. They might believe they can rely on the value of their raw land to repay their debts, but they are often mistaken. When a widespread disaster causes several of these situations to trigger at once, the consequences on a bank’s loan portfolio can be significant.

Early and comprehensive strategies toward reviewing property insurance can help banks reduce risk and avoid problems in the future. How this strategy looks in practice can differ between organizations based on their portfolios and services, but it often follows the same general principles. Following are proactive steps banks can take.

• Discuss insurance monitoring with your loan review function. Establishing property insurance costs as a proactive consideration across the loan review team or department is a critical first step toward preventing flag-worthy situations from going unnoticed.
• Regularly review current property insurance costs. Organizations should not assume that previous costs will match upcoming costs. Remaining in communication with brokers and insurers, including bank property, other real estate owned (OREO), and force placement providers, is critical in gathering information on the current market for each location financial services organizations lend to and operate within. That information can help establish guidance when assessing repayment capacity as part of the approval, annual review, or quarterly problem loan monitoring process.
• Incorporate property insurance costs into stress testing. If property insurance rate fluctuations are not an integral part of underwriting stress or sensitivity testing, now is a good time to add them.

  Organizations can use the data and estimates they’ve gathered and documented in guidance when stress testing, but they shouldn’t hesitate to explore beyond those numbers, either. The history of property insurance rates in some areas is proof that costs can rise well beyond expectations.

• Keep operations on top of property insurance monitoring. Property insurance costs are rising, but organizations could end up paying even more if coverage is allowed to lapse.

  It’s important to audit the current insurance monitoring service provider, whether it’s a third party or in house. How are renewal and cancelation notifications received and tracked? What processes and procedures are in place to resolve notices or lack thereof in an efficient and timely manner? Is operations actively reviewing and working with insurance monitoring reports in an effective manner?

  If an organization works with properties where the tenants and borrowers are responsible for maintaining insurance, it should monitor property insurance status to confirm coverage is both adequate and in force.

  If escrowing insurance for borrowers, organizations should be aware that properties in locations experiencing significant price increases might have large escrow deficiency after insurance payments are made. Banks likely will have to increase the borrower’s monthly escrow payment to account for the shortage due to next year’s higher payment amount and pay the deficiency. This double increase should be addressed when assessing repayment capacity as part of the annual review and problem loan monitoring processes.

  A proactive approach to property insurance monitoring can help avoid scrambles at renewal and leave organizations better positioned to protect their portfolios. At the very least, it’s a best practice to prevent going without something as important as flood insurance until the next open period.

Rising property insurance costs do not have to become a sudden obstacle in your portfolio management process if your organization has measures in place to anticipate and respond to them.

However property insurance costs might change in the future, you can determine your response sooner with a thoughtful strategy, an established plan, current market data, and a well-executed process.