Welcome to the blog AMA – What Is Driving Insurance Premiums?
Welcome and today I will share my thoughts on one of the vital financial aspects – insurance, derived from my podcast – the Real Estate Espresso. This blog post is another step in my AMA (Ask Me Anything) initiatives where I strive to answer your questions.
A Curious Query
Our exploration into insurance premiums is prompted by Ramon, who wrote me this interesting question: He has noticed insurance premiums increasing across the board and heard that this could be due, in part, to insurance companies’ anticipated losses in their commercial real estate portfolios i.e., increasing loan defaults, office building vacancies, and so forth.
Understanding Insurance
Although I’m not an insurance expert, there are some key insights I can share based on my conversations with insurance companies. Usually, insurance breaks down into two levels – primary insurance and Re-insurance (insurance over the primary coverage threshold). Each of these plays distinct roles in claim settlement.
The Particulars of Insurance
Let’s imagine a scenario where you have an insurance policy covering property damage up to a million dollars. If you have a relatively small claim, say $100,000 for water damage, your insurance company would handle it entirely. For cases where the damage exceeds the threshold, this is where Re-insurance kicks in, often underwritten by private families in the United Kingdom – such as the well-known Lloyds of London.
Investment Perspectives of Insurance Companies
An important factor to remember is that insurance companies’ investments are split between stocks, bonds, and alternative investments – with the latter making up roughly a quarter to a third of their investments. Even among alternatives, real estate only constitutes a minor portion, given its illiquid nature.
| Investment Type | Approximate Allocation |
|---|---|
| Stocks | ~35-37.5% |
| Bonds | ~35-37.5% |
| Alternative Investments | ~25-30% |
The Real Estate Holdings of Insurance Companies
When insurance companies do invest in real estate, they mostly lend on real estate assets, which include apartments, some office buildings, and industrial setups. They are incredibly conservative lenders, and they typically lend only up to 50% loan-to-value ratios in a first lien position. The borrowers must maintain high net worth, often in excess of five times the loan amount – emphasizing the conservative approach of insurance companies.
Addressing the Increase in Insurance Premiums
While commercial real estate values have experienced some fluctuations, particularly in the office assets space, it’s unlikely that this has caused a widespread increase in insurance premiums. Insurance companies are generally more conservative lenders than banks and hence, likely face lower risks.
The Rising Insurance Costs
There’s no denying that there is a crisis in insurance. Insurance costs for commercial property owners are burgeoning faster than inflation. However, the steep increase in insurance premiums is not due to losses in investment portfolios but rather about risk management. Reducing risk could result in lower premiums.
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