In this episode of The REconomy Podcast™ from First American, Deputy Chief Economist Odeta Kushi and Senior Commercial Real Estate Economist Xander Snyder discuss the dynamics fueling the dramatic increase in property insurance premiums and how soaring property insurance costs may impact residential and commercial real estate markets.
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“There actually are some silver linings and I like looking for silver linings nowadays. For that construction material prices bit, they have remained elevated compared to pre-pandemic, but annual growth in construction material prices has actually been declining or flat for the last several months, so that should relieve some pressure on rising insurance premiums. And for the reinsurance bit, it does seem that reinsurers appear to be willing to re-enter markets at the right price, which means that this declining reinsurance capacity that we talked about, and that was observed in 2022, is likely not a permanent trend.” – Xander Snyder, senior commercial real estate economist at First American
Odeta Kushi -
Hello and welcome to episode 74 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Xander Spyder, senior commercial economist at First American. Hey Xander.
Xander Snyder - Hey Odeta. For listeners who tune in regularly, Mark won't be joining today's episode, he's taking some time off, which means that this episode will surely bring the average down in terms of REconomy 80s references.
Odeta Kushi - Oh, no, what a shame. Mark will be missed, I guess we'll have to do without the 80s references in today's episode. Speaking of today's episode, today, we're going to cover a topic that economists are generally fond of -- risk -- how it's quantified and how to manage it.
Xander Snyder - Yes, and if you're a homeowner or commercial property owner, you may have recently run into some sticker shock when your insurance policy came up for renewal. On today's episode, we're going to take a look at the drivers behind those increases in property insurance premiums, as well as the impact of higher policy premiums on both residential and commercial real estate.
Odeta Kushi - One bit of clarification before we get going, today, we're going to be focusing on property and casualty insurance, sometimes referred to as P&C, which insures properties against catastrophic events and other types of damage. Before we get into what's driving higher insurance premiums, maybe we can start with a simpler question. Why do people purchase property insurance in the first place?
Xander Snyder - Well, from the perspective of commercial property, people purchase insurance to limit their downside risk. Commercial properties are often buildings which require a substantial amount of cash to acquire. And that means that there's a lot of money tied up in a single location. And since buildings are attached to the ground, you may have noticed they're exposed to whatever geography-specific risk that that location is exposed to. So property and casualty insurance limits the downside risk associated with uncommon events that could result in a large loss of money if something bad does happen. So a lot of deals make sense, if you know...a lot of people have heard of risk versus reward, right. And a lot of deals make sense if you have a reasonable upside and limited downside. But that same deal might not make nearly as much sense if you have reasonable upside and the potential for a complete loss.
Odeta Kushi - You know, this logic works pretty similarly for residential properties. While people who purchase homes to live in aren't exclusively using it as an investment, a house can still represent a family's largest single investment. Without property insurance, homeowners risk losing both their shelter and the substantial chunk of change that they saved over years to purchase the home in the first place. So, now that we know why people buy insurance to limit their downside risk in one way or another, why have insurance premiums gone up?
Xander Snyder - Well, while there are a number of dynamics that drive insurance costs, we're going to cover three big trends that stand out on this episode. First, there is a higher frequency of larger climate disasters with commensurately larger losses that have to be paid out by insurance companies. So the total number of climate disasters which resulted in large insurance payouts, over a billion dollars, have been increasing steadily since the early 1980s. And, similarly, the aggregate value of those insurance payouts for these larger than $1 billion events has also been increasing.
Odeta Kushi - So, just to be clear, that means if there's a climate event that results in losses greater than $1 billion, it's included in that total count and total value of losses.
Xander Snyder - That's right. And I'm sure the astute listener is already asking. Sure, sure, sure. But is that $1 billion threshold inflation adjusted? And the answer is, yes it is. And if you're curious, this data comes from the National Oceanic and Atmospheric Administration, or NOAA. They have a really nifty dashboard, where you can see this data and play around with it and these event losses are broken out by the type of catastrophic event. I'll be sure to post a link to this on X when this podcast goes up.
Odeta Kushi - Okay, so one driver of higher insurance premiums is a greater frequency of large climate events that are causing larger payouts for insurance companies. The next driver we're going to talk about is a bit more mundane. While high inflation over the last several years has impacted consumers pocketbooks. It's also driven up the cost of inputs to construction. Xander, you cover this regularly when the Producers Price Index is released, correct?
Xander Snyder - Yes, exactly. And if listeners are interested in any of that commentary, you can follow me on LinkedIn or on X ,formerly Twitter, @XanderSnyderX. So the producers Price Index, or PPI, is interesting because the data release includes thousands of sub-indices, which measure all sorts of things. One of those things is construction material costs, which have surged in price during the pandemic. While those prices are now starting to stabilize, they're still up between 35% and 40% compared to pre-pandemic levels.
Odeta Kushi - All right and higher construction costs translate into higher dollar amounts that insurance companies need to pay out to rebuild a damaged or destroyed property. The cost to rebuild a damaged property is often called replacement cost. And, as construction material prices go up, so to do replacement costs, with higher replacement costs, insurance companies are requiring higher premiums to offset the higher total dollar amount of insured property they are liable to cover.
Xander Snyder - So, in essence, things cost more than they did a few years ago. Sounds like a familiar story.
Odeta Kushi - Inflation rears its ugly head in yet another corner of the economy.
Xander Snyder - Kind of wish it would stop doing that.
Odeta Kushi - I think we all agree with you there. So the last major contributor to the recent surge in insurance premiums has to do with this thing called reinsurance. Now, to get a sense of what reinsurance is, imagine this. You're a regional insurance company that just covers a single state, you sell a policy to insure 50% of a $10 million commercial property. So you're on the hook for $5 million, if something happens to it. But maybe $5 million is too large of a liability for your business to cover. So you want to limit your downside by insuring a portion of that $5 million liability. To do this, you would go to a reinsurance company, which is a company that insures other insurance companies. Just like it sounds, right. So you, the regional insurer, buy a policy from the reinsurance company that covers 50% of your $5 million liability. Now, you've sold a $5 million policy, but are only on the hook for $2.5 million dollars in the event of a disaster. That's essentially how reinsurance works.
Xander Snyder - So reinsurance companies limit the downside risk that insurance companies face. So the total amount of this reinsurance money that's available to reinsure regional insurance companies risks, I feel like I'm getting tired of saying insurance.
Odeta Kushi - How many times can we say insurance in one episode?
Xander Snyder - Yeah, there is a pool of capital available to reinsure regional insurance risk. And that pool of capital is often referred to in the industry as reinsurance capacity in wonky jargon. And you can think of reinsurance capacity as just the total supply of reinsurance that's available in the market to regional insurance companies. So, if that reinsurance capacity shrinks, which just means that there were fewer reinsurers that are issuing policies, then regional insurers are faced with the prospect of higher losses that they're liable for, since they couldn't buy as much reinsurance to reduce their own liability. So to offset the prospect of these losses, regional insurers raise premiums.
Odeta Kushi - And that is exactly what happened in 2022. Reinsurance capacity or the total amount of reinsurance available to regional insurers shrank. This was driven in part by higher payouts related to recent climate events. However, some estimates indicate that reinsurance capacity as of the middle of this year is increasing from that trough, due in part to the higher premiums now available on new policies.
Xander Snyder - Higher prices attract more sellers.
Odeta Kushi - Exactly. Econ 101.
Xander Snyder - So, just to recap, our three main drivers of rising insurance premiums that we've talked about are -- one: the higher frequency and more costly climate events, two: higher construction material inflation, therefore replacement costs, and three: changes in that reinsurance market. So, of these, there actually are some silver linings and I like looking for silver linings nowadays. For that construction material prices bit. They have remained elevated compared to pre-pandemic, but annual growth in construction material prices has actually been declining or flat for the last several months. So that should relieve some pressure on rising insurance premiums. And for the reinsurance bit, it does seem, as you mentioned, that reinsurers appear to be willing to re-enter markets at the right price, which means that this declining reinsurance capacity that we talked about, and that was observed in 2022, is likely not a permanent trend, and more the result of market forces and prices changing.
Odeta Kushi - I will take the good news where I can get it. So thank you for the silver linings.
Xander Snyder - Yeah, no kidding. So now that we've more or less covered what's driving some of these higher insurance premiums. Let's chat briefly about what some of these impacts are for different aspects of the market. How do these higher insurance premiums impact the residential market, Odeta?
Odeta Kushi - Well, higher insurance premiums make owning a home more costly so, all else held equal, higher policy premiums impact affordability. If insurance prices increased by a lot, some homeowners may decide to forego an insurance policy entirely. Now this isn't an option if that owner has a mortgage on the house, since all lenders require property insurance, but someone that owns a house free and clear, for example, could choose, for whatever reason, to not have P&C insurance, which could lower their monthly housing expense, but potentially result in a complete loss of the value of their home if it is destroyed. Additionally, data from John Burns Research and Consulting found that almost a third of homebuilders in Florida said buyer's concerns about home insurance were somewhat slowing sales. The proportion in Southern California was similar at 29%. So higher premiums may be yet another headwind to home sales. Now, Xander, do you think there are any implications to higher policy premiums that are unique to commercial real estate?
Xander Snyder - I do think the dynamics are pretty similar. But when you're looking at commercial property, you're also thinking about the income it produces. And insurance premiums are an expense item that impacts income. And, in addition to higher insurance premiums, building owners are now also facing an environment with higher interest rates, as well as higher repairs and maintenance expenses, which is driven in part by the higher material costs that we talked about earlier in this episode. So combine all of that with moderating or declining rent growth across the country, and this all translates to distressed or declining profit margins.
Odeta Kushi - Yeah, today certainly is a challenging operating environment.
Xander Snyder - You can say that again.
Odeta Kushi - Well, thanks, Xander, for hopping on the show and chatting about what's going on in property insurance markets.
Xander Snyder - Yes, and while we recognize that insurance can be a somewhat technical topic, managing risk is an important concept. It was great chatting with you Odeta.
Odeta Kushi - It was great chatting with you as well, Xander. And thank you, listeners for joining us on this episode of The REconomy Podcast. If you have an economics-related question that you'd like us to feature on a future episode, you can email us at email@example.com. We really do love to hear from our listeners. And, as always, if you can't wait for the next episode, follow us X, formerly Twitter. It's @OdetaKushi for me and @XanderSnyderX for Xander. Until next time.
Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2023 by First American Financial Corporation. All rights reserved.
This transcript has been edited for clarity.