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Spencer Levy
This is Spencer Levy, host of The Weekly Take. This episode you're about to hear is about property and casualty insurance. We have this special announcement before the episode in light of the terrible fires taking place in Southern California. We recorded it on the morning of January 7, literally hours before the first of these major wildfires started making national news and prior to the most serious incidents of destruction. While the episode does not specifically address what’s happening in Los Angeles, it nevertheless addresses issues of importance to commercial real estate owners and developers dealing with hurricanes and other natural disasters. We hope this episode will help you make insurance decisions. But before we go there, we want to relay a special expression of our sympathy to all of the folks that have been adversely affected by the terrible fires in Southern California, with a special shout out to CBRE. We have a heavy concentration of our employees based in Southern California. Our sympathy, our love, goes out to all of you – CBRE and otherwise – hoping that these fires end sooner rather than later, and people can get back to a normal life. In the meantime, please listen to this episode of The Weekly Take, on property and casualty insurance in an increasingly uncertain world.
Spencer Levy
In 2024, there were 27 confirmed disaster events related to weather and climate in the United States with losses exceeding $1 billion each, according to the National Centers for Environmental Information. That trailed only the record 28 such events in 2023. Globally last year, natural catastrophes accounted for overall economic losses of more than $320 billion. Whether the biggest risk to your real estate is tornadoes or hurricanes or cataclysmic wildfires like the ones in L.A., one industry is focused on the business and challenge of the aftermath of such disasters. On this episode, a primer on big questions and financial products that real estate professionals should consider packing in their emergency prep kits.
Ryan Barber
Insurance is there to pay the claims when they happen. Well, the frequency of those claims is becoming more often, and the severity of those claims is going up.
Spencer Levy
That's Ryan Barber, Global Head of Property at Aon, the multinational financial services company that specializes in risk and human capital. Now in its fifth decade of operations, Aon provides strategic and practical advice on understanding risk, the cost of risk, and of course, insurance.
Raphael Dawson
What we're doing about those issues is trying to mitigate not just the cost of the insurance, but mitigate the financial exposure to losses that are not covered by insurance.
Spencer Levy
And that's Raphael Dawson, a Senior Principal of Walton Street Capital, a private equity firm with both debt and equity vehicles focused on U.S. real estate with more than $15 billion of assets under management. And to help us with greater context, our roundtable also features CBRE’s Chris Nassa, a Senior Vice President who oversees insurance globally for CBRE, including the company's own corporate risk, as well as advice for clients on transferring their risk through the insurance market.
Chris Nassa
Now we're really getting to the point of, you know, the segregation of risk and insurers looking at your risk quality and getting better rates based on their risk quality.
Spencer Levy
Coming up, the ins and outs of property and casualty insurance. How the business works. How to manage risks and costs. An episode filled with news you can use. I'm Spencer Levy, and that's right now on The Weekly Take.
Spencer Levy
Welcome to The Weekly Take, and we're going to cover one of the most important, hottest topics in real estate that, candidly, we hadn't thought about much for years until recently when it became a significant cost increase. And that's property and casualty insurance. To help us break down this issue, we have three of the leading experts in the space, starting with Ryan Barber, Global Property Leader for Aon. Ryan, thanks for coming out.
Ryan Barber
Thanks for having me, Spencer. Insurance typically is not the hot topic of the day, but I look forward to having a conversation about that today. I look forward to having a good, productive conversation today.
Spencer Levy
Great. Well, thank you, Ryan. And my friend Raphael Dawson, Senior Principal at Walton Street Capital, one of the largest real estate private equity firms. Raphael, thanks for coming out.
Raphael Dawson
Well, thank you so much. Glad to be here.
Spencer Levy
Great to have you, Raphael. And then our own Chris Nassa, Senior Vice President, CBRE, who deals with CBRE’s insurance issues. Chris, thank you so much for coming out.
Chris Nassa
Thank you, Spencer.
Spencer Levy
So, Ryan, let's begin big picture. As you mentioned, this may be the first podcast or call where people suggested that property and casualty insurance was, quote, “the hot topic”. Well, I wasn't making that up. I had never really talked about property and casualty insurance in my market overviews until a couple of years ago until the costs went stratospheric. What's your point of view? Why are we talking about this today, Ryan?
Ryan Barber
Well, I tell you, we have gone through one of the most prolonged hard market cycles that we've seen since certainly I started in the business in 1995. And the reason it's become a hot topic is probably not for good reasons, and that is the cost of insurance over that time period has risen to kind of record levels. And as an operating expense, it's now causing an issue with the financials on assets and the performance of funds. And so it's become the hot topic. What's driving those changes are a number of factors, a confluence of things, really. We can start with just climate and the frequency and severity of the claims that we're seeing, right? At the end of the day, insurance is there to pay the claims when they happen. Well, the frequency of those claims is becoming more often, and the severity of those claims is going up. The claims payouts themselves are growing and the size of those claims and settlements on casualty set are just getting larger. And there's a number of things that are driving that. You can't talk about why that's happening without talking just about demographics. And if you look at shifting populations and where that's occurring, you see a mass shift of population to areas that are significantly prone to catastrophic risk. You look at where populations in the U.S. are moving; They're moving south, They're moving to the Sunbelt, to places like Florida and Texas. They're moving out west in areas that are prone to wildfires. And along with that just becomes a concentration, a large concentration, of exposure in those areas. You look at the amount of development that's going on. You look at your own businesses and where you're investing in building multifamily properties or high rise towers or where we're putting distribution centers. It's in the areas where the population is at. So you have an increasing population and increasing exposure base that is subject to these catastrophe claims.
Spencer Levy
Raphael, tell us what Walton Street's doing about the issues that Ryan just laid out.
Raphael Dawson
What we're doing about those issues is trying to mitigate not just the cost of the insurance, but mitigate the financial exposure to losses that are not covered by insurance. We can debate, you know, hurricane deductible and how it has increased over time. Well, you're basically self insuring for that first layer. What are you going to do about that risk? Because the carriers have rightly calculated that few of those hurricanes are going to get above that deductible. So what can you do to mitigate physical risk under that cap, if you will? The other big education effort that I'm engaged in is dealing with our asset managers and property managers to understand that weather patterns are shifting. And for instance, no one would have expected hurricane damage in Asheville, North Carolina. But here we are. No one ever expected that we would have basically the remainder of a hurricane as a tropical storm winding up in upstate New York. So you've got areas that are now subject to significant risk that previously were not. And it's dealing with preparation for that: simple planning and mitigation. How can you do that at the property level? We are working actively to manage insurance costs, but we can't ignore the fact that there's a lot you can do on the ground to mitigate physical risk at the property. And unfortunately, the real risk to us is not property. The real risk is people. So the first thing we have to do is to assure occupant safety. Second thing we work on is continuity of operations.
Ryan Barber
Raphael, I think I just want to reiterate a point he made, because it's a really important one. And that is just the change in the nature of losses that we're seeing.
Raphael Dawson
Absolutely.
Ryan Barber
So we talk a lot about hurricanes because we see those on TV and they're reported by CNN. But if you look at the events, it's not just hurricanes or floods. It's now we're dealing with convective storms all the time. Multiple multibillion dollar events in a given year. We've got freeze claims going on in places like Houston, Texas. Who would have thought that you'd look at your back window and see your pool frozen in Houston, right? We've got hurricane claims, as Raphael suggested, coming up in the northeast. I live in New Jersey. We get tornadoes now in New Jersey. We never saw these things before. You've heard people start talking about atmospheric rivers. I mean, that's a whole new one. So it's just the ability for insurers to adequately price risk depends upon predictability, right? So if you think about life insurance and auto insurance, it's highly predictable, right? An actuary can run models and with a high degree of certainty determine what those claims are going to be, because there's a huge frequency of that. We don't have that in large commercial property risk. We don't have thousands and thousands of hurricanes or thousands of freezes or floods or anything. So it becomes very difficult to predict that. So the insurance industry has developed tools and models to try and help with that predictability and figure out what the expected losses are going to be so that they know how to price the product. But the claims are changing and where they're coming about. So the insurance carriers and actuaries are having a hard time staying ahead of the actual losses and adopting the models to account for things because everything's just changing.
Raphael Dawson
One of the difficulties we have is getting people to pay attention to the risk that wasn't there five years ago. And just as an example, we, Walton, closed on a student housing project in Boone, North Carolina: Appalachian State. That's about 25 miles from Asheville. So three days later, a hurricane hits. And that was not, to be honest, part of our underwriting. We did, however, look at flood. So it worked out okay for us. But that's one where we just did not expect a hurricane in Boone, North Carolina. And we have to deal with an increasing awareness of risks that just weren't there before. And I guess one of the great scorecards for this that I use with our people is NOAA’s billion dollar loss map. And since 1980, NOAA’s been keeping track of losses in excess of a billion dollars for floods, hurricanes, hail events, whatever. And the short of all that is from 1980 to 2024, the average was 8.5 events per year, CPI adjusted. The average in the last five years, since 2019 is 20.5.
Spencer Levy
And by the way, NOAA stands for the National Oceanic and Atmospheric Association, which oversees the National Hurricane Center and other folks that are monitoring the weather. But keep going Raphael.
Raphael Dawson
The point is to reiterate what Ryan said. You've got more risks, and there are other factors which contribute to that. You're building more in harm's way. You've got a higher per capita value in high risk locations. And again, one of the problems we have is that our values are not keeping up with the increase in construction costs. So we have found ourselves in circumstances where we have to pay much more attention to what our insured value is, because you certainly don't want to claim on something whose value turns out to be well in excess of what you declared. Hard to keep up. And people get frustrated with the fact that the replacement cost is now greater than the market value. The insurer doesn't care. They care about replacement cost.
Chris Nassa
That's a huge part of it, Spencer. I think Ryan and Raphael talked very well about the insurance part of it in that the losses are getting worse, losses are happening more frequently. But the other side of it is construction costs have increased tremendously. So if your building was 5 or 6 years ago valued equal to cost X to replace, it's multiples of that now and that needs to get factored into the insurance costs, as well. So the increase, a lot, has happened because of construction costs.
Spencer Levy
So, Chris, let's stay with you for a minute. This is Chris Nassa from CBRE. Chris, by the way, before we go any further, just make the just very basic distinction. What is property insurance? What is casualty insurance?
Chris Nassa
Sure. So property insurance is your building burned down, this is what pays you back for the cost of your building burning down. Versus casualty insurance is, a third party slips and falls on your property and sues you. That's the coverage that you have to protect you from third party liability from external people suing you. So property insurance, you know, we're getting back to really being judged more on your risk, your specific loss history, the quality of your assets is really guiding your pricing now on the property insurance side, and prices are starting to normalize. We're going through our renewals right now and we're seeing really good outcomes in renewals. The casualty insurance side, though, is where the next wave that's starting to crash, and it's not going to be anywhere close to the wave that we experienced on the property because it's just not as big a percentage of the cost. But casualty insurance costs are increasing, and that's due to medical inflation. It's due to just the more litigious society we live in today. And that's kind of the next wave we see crashing where costs on that side are really starting to increase. And from a size perspective, it won't be as big as property, but as a percentage increase of what your cost was last year on the casualty side only, you're going to start seeing some big jumps in that space.
Spencer Levy
Got it. And let's talk a little bit more about just raw numbers here. And again, I don't want to put… this is not fear factor. This is just raw numbers. I heard some pretty scary numbers in places like Florida for multifamily, of property and casualty insurance costs going up by 2, 3, 400%. What kind of numbers are you seeing, Chris?
Chris Nassa
A lot of what happens in the insurance world is based on the leverage you can generate by the size of your portfolio, right? If you're an individual asset owner or small owner of a few assets, those numbers are probably legit. Over the last five years, you've probably seen 100 plus percent increase in your insurance, maybe more depending on your loss history. If you are congregating your assets together and creating leverage in the insurance market by having a good spread of risk, you're able to mitigate those losses. I'd say specifically in the investment management portfolio, we’ve probably seen maybe 30% increase over the last 4 or 5 years because very high quality assets haven't had a lot of loss activity and a good spread of risk amongst both high hazard and non-high hazard places.
Spencer Levy
Raphael, how does Walton Street mitigate the cost of insurance?
Raphael Dawson
Well, again, there's two factors. One is the actual cost of insurance, the premium you pay. The second is the risk you face for uninsured losses, be that part of your deductible retention, whatever we're calling it. If you've got a hurricane, it's, you know, 5% of value. So you've got that first 5% is yours. And that involves doing basically a resilience assessment of each property, determining where the risks are, and then figuring out what changes you can make to either the site or the building that are going to reduce your risk. I mean, there are simple things. The seismic shutoffs: great for earthquakes. The floodgates: great. There's also an awful lot of risk associated with the people. In particular resort properties, they are your biggest risk. You can buy a lot of drywall, but it's really tough to manage the people risk in a resort because there's a weird subset of the world that wants to be in a hurricane and become an Internet star. So one of our biggest problems is emptying out a resort in advance of a hurricane. So there's people management here that is difficult, and that's something that the managers have to face. The architectural and design changes can be extremely expensive. So you have to very carefully calibrate what you're willing to do at a property with what the perceived risk is. And the modeling of risk is changing because the weather patterns have changed. So if you're using what was traditionally a 10 or a 30 year model of historical information to extrapolate forward, you're going to get an artificially optimistic view of what can happen to you. You really need to be focused on information over the last five years. And that's a big data crunch. And the models are catching up to it, but they're not there yet.
Spencer Levy
So let me keep it simple, if I can. I'm going to break this into two halves of the conversation. One is the micro, property level decisions that can be made to mitigate insurance risk. And the other is the macro, which is pooling assets together, going to multiple insurance companies. So let's start with the macro. Ryan, you're dealing with companies like CBRE, IM, Blackstone, Principal, all the biggest owners of properties in the world that own tens of billions of dollars of real estate. And then you have smaller owners who own less than a billion of real estate. How do you help both of them mitigate and/or manage their property and casualty insurance costs?
Ryan Barber
So the first thing I would say is if you think about what's going to drive costs, it's how much insurance are you buying? How much risk are you willing to retain? What's the quality of your assets? And then what's your individual loss experience look like? And when the cost of insurance over a very prolonged… we went 27 quarters in a row with pricing going up. This issue went well above risk management and it's now into the C-suite. And people wanted to know this is not sustainable. This is now impacting the performance of our portfolio. What can we do to contain cost? And the first thing I say to clients is understand why you buy what you buy, right? So a lot of clients over the last handful of years have really taken a fresh approach to their insurance programs. And that starts with understand what your exposures are in your portfolio. What is that potential expected loss based upon your individual risk profile of your assets and where the aggregations are? Use sophisticated analytics and models to understand those loss expectancies and how those loss expectancies compare to your own risk tolerance. Understand what your loan covenants say and what your lenders require you to buy. Enhance those models with better data that is going to give you more confidence in the outcome of those models. And use that to make informed decisions on your program. And that enables you to then rightsize some of the limits that you're buying because you've gone through a deep analysis, you've got better data, maybe the lost expectancy is less. You can choose to buy less insurance. That's going to certainly impact cost. The other thing is to look at how much insurance do we want to buy? Does it make sense to try and buy insurance at low deductibles? Or does it make sense, is it more capital efficient to fund your normal and expected losses, either through deductibles, through retentions that you can take in addition to deductibles, through utilization of the captive insurance company, which is for some of our larger clients…
Spencer Levy
Let's pause there for a moment. I've heard the term captive insurance company. I also know that several of our largest clients flat-out own insurance companies. KKR owns one. Blackstone owns one. So tell us the distinction between the two.
Ryan Barber
A captive insurance company is a legal entity, an insurance company formed by an owner, which is utilized to retain and self-insure risk. And it is funded. There are capital requirements behind it. It can be used within programs to retain and fund deductibles or retentions. It can be utilized within the actual risk transfer layers to take on certain portions of risk. Many of the clients that have captive insurance companies will then… it also enables them to tap into the reinsurance market, which gives them access to a whole different pool of capital to buy reinsurance protection so that they can take a defined amount of risk within their captive. But it's essentially a form of self insurance, but in the form of an owned insurance company.
Spencer Levy
Now, how big does an entity need to be for that to make sense? Do you have to have a billion dollars, or more of assets? Who is the smallest company you would say I'd recommend this for?
Ryan Barber
It's not so much about the size of the company, but rather the complexity of their risk and how much they're spending for insurance, right? There's an inflection point at which the cost of buying traditional insurance versus self insuring it becomes a bad trade. So if you're paying on an insurance program, and I'm going to use some insurance lingo and then I'll explain it, a 30, 40, 50% rate on line. And what I mean when I say rate on line, if you have a primary $25 million layer in your insurance program and you're spending $10 million or $12.5 million. So if you're spending $12.5 million to buy $25 million of coverage, that's a 50% rate on line. Your premium divided by your limit. When you get to those points, you have to ask, is that a good trade anymore? Where at that type of pricing, is it better for me to fund that on my own through a captive insurance company. If the claims don't happen, then we keep the profits within the captive as opposed to letting the commercial insurers take that profit. So there could be a small, mid-sized multifamily portfolio. If that portfolio happens to be in catastrophic areas such as Texas or Florida, they can be paying significant money. You know, they could be less than $1 billion and a captive might make sense for them. But certainly when you're talking about companies that have 10, 20, 50, 100 billion dollar portfolios, captive insurance companies make a lot of sense and you see them utilized with more frequency.
Spencer Levy
So, Chris, how do we deal with this?
Chris Nassa
Yeah. So we do have a captive insurance company that CBRE uses to insure some of our risk. And right in line with what Ryan said, right? We look at opportunities in the marketplace where we think our program is not priced as efficiently as it would be in the market, and we believe in our risk, simply said, more than the market does. And we think we can price it better. And we do. And ultimately there's a downside risk to that because you're taking the downside risk if losses start to happen. But if they don't happen and your bet is right, it's a really good financial risk trade. The other thing I wanted to add was there are shared captives out there. There are opportunities for clients to potentially buy into a captive structure that they don't have to own and still reap some of the benefits of captives. And they should be talking to their brokers about opportunities like that.
Spencer Levy
And I've heard that idea where you have 2 or 3 mid-sized companies teaming up into their own third party, I guess, jointly owned captive. Is that fairly common, Ryan?
Ryan Barber
Well, you have captives which can, from a property standpoint, can do risk pooling for the purposes of taking retention. You can't have independent companies that come together and buy insurance together because there's regulations around risk purchasing groups and whatnot. One of the benefits that CB Richard Ellis, that you provide to your customers on your property management business is you create insurable interest through your property management contracts, whereas the overall property manager, you've taken on the contractual responsibility for procuring insurance on behalf of your clients that you're managing properties. And that enables independent owners to pool their risks together and participate in a shared program. So that's a tremendous value-add service that you guys offer to your clients.
Chris Nassa
And that's something we do offer to our clients who are property management clients of ours. And I will tell you that program has grown by over 100% in the last five years. And the reason for that is because it provides such a great deal on insurance through pooling our assets together, through getting the best rate, through the quality of our insurers. And it's really been a real benefit to our clients.
Ryan Barber
And we, because, Chris, that's been consistent. When I look at our large commercial real estate clients that have, I'd call, a sponsor program through their property management businesses. Those programs have exponentially increased in the last five years. And insurance is a big driver of that.
Raphael Dawson
I just wanted to make the comment as far as self insuring or captives. In our business where we have multiple funds, there is great skepticism amongst the investors as to the wisdom of either a captive or other, what you were describing as typical risk management techniques. They're concerned about mismanagement and basically unknown risk. So if you are to engage in that, someone within the company is going to have to take the time and develop the expertise to be able to fairly evaluate and explain that to your investors who are going to take a jaundiced eye at what they regard as a huge potential for unknown risk.
Ryan Barber
Yeah. And in those, whether it's utilization of captives or shared retentions that are being taken for our real estate clients that don't want to take kind of unfunded balance sheet liability because they don't own the assets, they might just be a fiduciary, or they're property management. Those retentions, whether it's in the form of a captive or it's just an aggregate retention on a program or you utilized alternative risk transfer products such as structured risk, which is being utilized with increasing frequency. There typically will be a maximum liability or retention associated with that, which for real estate clients tends to get fully funded so that there is no… you're protecting that downside risk. So through these captive programs, you're not taking on unlimited liability that can have an adverse effect on runaway costs.
Spencer Levy
So let's shift now to the micro. And micro, I'll put into two basic categories. One of the categories is how do you shift your insurance purchasing decisions, such as do I have a higher deductible versus a lower deductible? And the other is, I'm building this property today. Do I build it at plane or do I build it three feet above the floodplain? Now, that second decision I think is more interesting because it brings in the bird in the hand versus the two in the bush problem. Because you're clearly going to be more resilient. But are you going to get that money back on the back end when you sell the property? And more importantly, will you get it back in the form of lower insurance premiums today? So, Raphael, I’d love your reaction to that observation.
Raphael Dawson
Well, the observation is valid and the results, at least in our experience, are inconsistent. First, to your point. Do I build it three feet higher? There's a great deal of difficulty in accurately assessing flood tidal surge risk because much of the data is ancient. FEMA maps are over 20 years old in the main and cannot really be trusted. There's tremendous political strife involved with updating a FEMA map to make it accurate and useful. You wouldn't want to be the poor person from FEMA who has to go into a public hearing and try to explain why he's moving the flood zone because there are losers in that argument. And thus updating FEMA maps tends to be a 10 or 15 year process by which time they're basically out of date again. So you can't trust a FEMA map is where all this goes. So then you have to go to alternate providers of risk assessment for flooding and determine how high up you want to build. Now, do you get any benefit from a carrier for doing that? I would say that we have not yet experienced a consistent appreciation for resilience efforts. We are doing it to mitigate the exposure we have to the deductibles. We hope at some point the carriers will start responding by making a material reduction in premium. But we're not there yet, or at least we haven't seen it yet.
Chris Nassa
I think we're starting. I think we're starting to move in that direction. Insurers in that direction, where 3 or 4 years ago, this was a tide that rose all ships, right? Insurers were not making money. They were being crushed by everybody. Didn't matter if you were a great account or a bad one, your premium was going up. Now, we're really getting to the point of the segregation of risk and insurers looking at the risk quality and giving better rates based on their risk quality. Now Spencer, I don't know if you'd really ever see it necessarily at the individual asset level where building that building three feet higher is going to save your money on insurance in a bigger type program because that's not necessarily getting factored in. But I think the pitch that I mentioned this earlier was telling your clients that, hey, we are a more resilient asset that will be up and running sooner after an event happens, so why would you not want to lease with us versus leasing down the street? That risk quality is something I think needs to start coming out more in the leasing space.
Spencer Levy
So folks, there's a lot of uncertainty, or rather, things people just don't know about how insurance premiums come about. Many people get their bills every month and or every year and say my insurance rates went up. I'm not quite sure why. But in commercial, it's a much more sophisticated process, certainly from the consumer side to try to mitigate those costs. So, Ryan, perhaps we'll start with you. What exactly is insurance modeling? How do certain factors go into determining your premium?
Ryan Barber
Commercial property insurance has its challenges when it comes to loss predictability. It's different than other lines of insurance like auto insurance, like life insurance. In order to price an insurance product, underwriters need to have certainty or predictability in the losses that are going to happen. So when you have lines of coverage that have high frequency of claims, millions and millions of claims, the predicted losses are very accurate. Again, akin to auto insurance, life insurance. Commercial property insurance is really driven by natural catastrophe risk: earthquakes and floods and tornadoes and hurricanes. And while it seems that there's a lot more frequency to those claims, from an actuarial standpoint, that sample set of claims is very, very small. So the insurance industry has developed over many, many years, models that help predict not only the frequency of claims, but the severity of claims and what those loss outcomes are going to be. It helps them to price product. And so what they do is they use the limited amount of historical information that we have on natural catastrophe claims, and they use that to create a robust set of events, predictive models. So they'll develop a theoretical 10,000 year event set for earthquake, for hurricane, and then they build a model around that, where there's a hazard function to the model, where they're looking at the predicted frequency and severity of events. Then they have to build the damageability function to the model where they say, okay, on this type of event occurring in this area to this type of property, whether it's an office building or a wood frame, multifamily property, what is the expected damage to those events? And then there's a financial part of the model which then says, if I overlay terms and conditions, things like deductibles and the amount of limit, what is going to be that expected loss? So models have become an integral part of the commercial insurance business. Whether you agree with them, you think they're accurate or not, they are the reality. So it's important that clients understand what goes into these models, the role that they play in the outcomes of the models in terms of the data on your portfolios. We spend a lot of time working with Chris and the team to give us really fine details on CBRE’s portfolio. We want to know the types of properties, the year it was constructed, the materials that are used. All of this detail that goes into the model helps refine those models, makes them more accurate, reduces uncertainty and ultimately cost. There are those that get really upset about models because historically, when you compare them against the actual losses, if I go back to, I think it was 2006, where we saw Hurricane Katrina, Rita, and Wilma come through. The losses that we saw were significantly greater than the models. I think when you look at the hurricane that went all the way up into Asheville this year, I don't think the model anticipated that. So we have to recognize that models themselves are inherently flawed or they're inaccurate because they're manmade. And so as we've seen an increasing frequency of claims, the models have been adjusted to reflect that increase in claims. When you look at the actual losses sustained, say, down in Houston, they update the vulnerability curves for based upon the losses that they saw that underperformed. So the models are constantly being tweaked. They are a lot better today than they have been, but again, they are just a model.
Chris Nassa
Ryan gave a great technical explanation of what the models are. But when the real estate folks listen to this, think about this. It's a tool. It's a tool in your toolbox to help you think about your risk and do the right buying decisions. Making sure you're buying enough limit. Thinking about what your retention risk is. Things like that. The way we think about models at CBRE, we use the phrase saying, “All are useful. None are correct.” Right? It's a tool for us to look at, to think about how we're going to buy risk. But ultimately, we know it's not going to be right when the event happens. It's just a guide to help us think about buying risk and how these events are going to play out.
Raphael Dawson
I would like to add, from the owner's standpoint, a very important point. The quality of information the owner provides for the modeling exercise makes a big difference. Inaccurate information provided or no information provided results in the carrier assuming the worst case scenario. So you don't get credit for any of the good things you did at the property, because they're going to presume the worst case because that's what you do in the absence of information. There is a tremendous return on the time spent correcting the information submitted to a model for insurance purposes, because otherwise you're not going to get the new roof. You're not going to get the fact that you're concrete. You're not going to get any of those good things factored into your pricing.
Spencer Levy
And some of those things, Raphael, are done by third parties like engineering firms that will dig, particularly if you're buying the building versus building it. Building it must be a little bit easier to say this is actually the materials we use. But when you're buying it, aren't there some mysteries behind the walls?
Raphael Dawson
Well, there are always mysteries, and it depends on the questions you ask of the people doing your due diligence inspection. One of the things that Walton is now doing is we have expanded our due diligence questionnaire to include all of the data requested for the majority of risk modeling. So we have engineers crawling around the building trying to answer those questions, which we know will be asked. And it prevents the well, somebody has got to go back later. How much attention are they paying? Did they really go look in the right place? We're trying to give as accurate a picture as humanly possible of the physical condition of the property.
Ryan Barber
And let me just state what… I want to give an example of some of the things we're talking about. When these models are run, there's four basic pieces of information you have to have on a property to run it. You need to know what is it? Is it an office building? Is it an industrial property? Is it a multifamily property? So what is it? What's its basic construction? Is it wood frame or steel frame or concrete? What year was it built? And how many stories tall is it? So those are the four basic pieces of information you have to have. They call those primary characteristics. And then there's a whole slew of additional information called secondary modifiers, and that's details on you might have an engineered foundation on that property. You might have seismic bracing on the walls, how your equipment's anchored to the roof, the types of windows, the finished floor elevation. And when you include that secondary modifier information, it takes uncertainty out of the model. It reduces the average annual loss expectancy at the individual property level, and that is a key term there. AAL: average annual loss expectancy. There is a direct correlation between that number and what you pay in premium, right? Insurers will sometimes charge two, three, four times that average annual loss expectancy. But when you spend the time to collect the additional information that we were referring to and that information could be available in a property condition assessment report, in a seismic engineering report, in a geotechnical report. That information, when included, oftentimes can reduce the AAL by 30, 40, maybe 50%, which can translate into real dollar savings. I can't stress more importantly the impact that you can have as owners on maintaining and collecting really robust data on your properties.
Spencer Levy
Let's go full circle now to you, Ryan. So the question really is… I get it. If you're self insurance it's almost a no brainer for resiliency purposes to spend a little bit more money to reduce your individual risk. But the insurance companies, it sounds like, are lagging behind. What's your perspective?
Ryan Barber
Two things, and I agree with the comments made by both Chris and Raphael. Some of these decisions, whether to raise deductibles or not raise deductibles, aren't decisions that have been put in the hands of clients. Insurers have mandated and required them. We've talked a lot about increasing cost. But the other big increase in our clients costs… when I think about cost for commercial insurance, it's not just what you pay in premiums, it's what you retain in losses through your deductibles. And insurers have forced clients to take higher deductibles and retentions. And therefore, some of those decisions as to how we build our properties, where we buy our properties is impactful on your total cost of risk because you're retaining a lot of that. Now, not through choice, but because that's the way commercial insurers are selling these contracts. The other thing is, is some of this is whether or not… when you're when you're buying an asset or deciding whether to purchase or develop an asset in a particular area, you have to ask the question, is that asset going to be insurable in the future? And part of this sustainability and resiliency is we got to be smart about where we are putting assets, right? If you look up and down the coast of the U.S., the East Coast and whatnot, and we've got trillions of dollars of exposures that have been built up on barrier islands that are large sandbars. And so if you want to have those assets, they're going to have to be built in a particular way or they're going to become uninsurable. It's not just a matter of impacting your cost on an annual basis at the asset level. It's whether or not we're building a resilient portfolio that is going to be eligible to be insured in the future in some of these areas.
Spencer Levy
One of the areas that we haven't talked about here is the split between private insurance, which is what your business is, Ryan, and federal insurance. Federal flood insurance, and federal flood insurance, there has been talk about them saying certain barrier island assets may not be insurable. So when you take a look at these two pockets of insurance money, federal and private, how do you advise clients to look at both?
Ryan Barber
There's a massive difference between private insurance and federal insurance. Private insurance has a mandate to make a profit, writing insurance on behalf of their shareholders and investors. And therefore they need to price risk and develop models that can predict losses and price in their expenses and ratios and deliver a return. A federal insurance program, which is, as Raphael was mentioning, there is a lot of political pressure around these programs to make insurance affordable. And they're not necessarily, the premium and the pricing models aren't developed in what a private insurance company would say is an actuarial sound way, meaning they are not charging the premiums necessary to pay for the expected and eventual losses. But they don't really have to because they've got a relief valve in the sense that if they're underfunded, they're going to be, they get a federal backstop, a bailout, i.e. us taxpayers, who are just going to be assessed to fund these programs. So it's really apples and oranges comparing federal insurance and private insurance. It's not that private insurers aren't willing to write flood risk or they're not willing to write wind risk in Florida or in Louisiana or Texas. But you have these government pools that come about, and so people utilize them because it's a cheaper form of risk transfer for them. It's not comparable to private insurance because it's government funded and backstopped.
Chris Nassa
And the coverage isn't as good, right? In the federal programs, the coverage is not there. And I don't know if anyone else in this call has ever adjusted a NFIP claim, a National Flood Insurance Program claim. It's one of the worst experiences of my life. So that is factoring in as well, where it gives people some sleep insurance and makes them feel better. But the coverage that they're actually getting out of it is not great.
Spencer Levy
Raphael. Federal versus private?
Raphael Dawson
I'm going along with what Chris stated. A claim under the federal program can be an excruciating experience and one that is not something a neophyte should go into.
Spencer Levy
So a word that was used on this call a couple times by you, Ryan, was insurability. Is this asset even going to be insurable 3, 5, 10 years down the road? Raphael, from a Walton Street perspective, how do you look at this when you’re on an investment committee. Are you redlining certain areas? Are you saying build versus buy? How do you look at it from an investment standpoint?
Raphael Dawson
From an investment standpoint, it has to get to property-specific risk quickly. And your comment about construction, if you build it, you can build it to a higher standard, improve your resilience, reduce your likely loss. The question then comes to how long do you intend to hold it? If you're doing a transaction in our core portfolio where it's a ten-year hold, versus an opportunistic, where your target hold is three years, that's a very different set of math. And in the three year hold, you have to be much more concerned as to recovery of that additional investment. Is the next buyer going to compensate you for the improvements you made that are likely to benefit them over the long haul? So it gets very quickly to property specifics. We have purchased property in Florida recently and it's a long conversation as to exactly where it is and what those risks are. Who controls the retainage ponds immediately adjacent to the industrial building? Has anybody examined the lift pumps? I mean, you get down to that level of scrutiny because it really matters.
Spencer Levy
So, Chris, you cover CBRE’s insurance programs globally. And again, this is primarily in America. But when you look globally at how insurance is handled both within the United States and outside, are there any lessons to be learned for American investors from some of your experiences from Asia or Europe?
Chris Nassa
Yeah, I think the first thing that we learned many years ago was that the insurance markets in each region are very different, and trying to put together a true global type program to insurer a property in the U.S., in Europe, in Asia, is extremely difficult because the rate structure is different, the coverage structure is different, the retention structure… It’s just not reasonable. It's not feasible. We have moved towards regional programs, country programs, things like that to protect our assets because we couldn't put together something globally. I think that was one of the biggest lessons that we learned because we're so used to putting large programs together again to leverage the insurance market and get the best rate, and we just weren't able to do that. I'd also say I think the protections that happen and the actual…. there's a lot more risk transfer that happens. The retentions are lower, the deductibles are lower outside the U.S. The market is a little, I don't want to say behind because that's got a negative connotation with it, but almost a little behind some of the way insurance is put forward and procured here in the U.S..
Raphael Dawson
Having had to do claims in properties in Mexico and India, I can tell you that the regulations applicable to those claims are entirely different than they are in the U.S., and we unfortunately come to the deal with the perspective it's all going to be like the U.S. It is not. And you need local expertise to understand the practical risk you're taking. It's very different than what might be on paper as to what the policy in effect really is. And you need a local expert.
Spencer Levy
Chris, we're at a point today where insurance has gotten a lot more expensive, though I understand it is stabilizing a bit now from where it was in the last year. But we're also getting a whole lot smarter on this issue from both a macro and a micro perspective. So two questions. Number one, the bottom line, where is cost going in the next 5 to 10 years? And second, what are we doing about it?
Chris Nassa
In terms of where we're going, we talk a lot about property insurance, and that's really the driver from a cost perspective. You're a real estate property owner. Property insurance is your biggest bottom line number that you're facing. However, casualty insurance is getting much more expensive right now. So we're seeing two things happening. Property insurance is kind of flattening out, right? Insurers have started to make profits again. The costs are starting to normalize and we're really going back to that. You're being judged more on your risk than that tide that was rising all ships that I mentioned before.
Spencer Levy
So, Raphael, next to you. Where are we going over the next 5 to 10 years in terms of cost, bottom line, but also what you, Walton Street, are doing, what our industry should be doing to mitigate this risk going forward.
Raphael Dawson
From a premium cost, I would expect to see a slow movement towards the accurate pricing of risk. South Florida is going to continue to go up. South Dakota probably goes down to be a more accurate reflection of the real financial risk the carrier or the owner has. And for a long time, low risk areas have effectively subsidized high risk areas. And we're going to see a move towards accurate pricing over some period of time. The business overall, I mean, insurance historically was a little backwater and it was a small part of operating costs that didn't change very much. And there wasn't a great deal of sophistication on the part of the client, and in some cases, on the part of the broker. One of the takeaways I would offer to anyone listening is that someone within the firm is going to have to develop a level of expertise or find a consultant that they truly trust, because we're in an increasingly complex insurance environment and the cost of being wrong is going up because the retentions are up, the deductibles are up. Insurance used to be viewed as sort of a blanket that covered everything over $15,000. Well, that doesn't exist anymore. And this is not a temporary fluctuation in a market. It's an evolution of a market. So it's not going back to where it was ten years ago. And we as owners need to understand that, staff internally as appropriate, to develop some knowledge and be an intelligent customer. And we've not always done that as customers.
Spencer Levy
So, Ryan, we'll give you the last word. How do you see the business evolving specifically within commercial real estate over the next 5 to 10 years, both from a cost and a risk management standpoint?
Ryan Barber
So good news, bad news. Good news is we're in a stabilizing market. We're in a period where pricing is leveling out. We're seeing a return of competition. Companies like CBRE are in line for a very favorable renewal. The long term trend is still going up, right? If you just look over the last 10, 15 years, the frequency and size of claims is going up. Populations keep moving to the areas that we talked about. So the long term trajectory is very challenging. And so for clients, I think you hit the nail on the head when you talked about sophistication, it's no longer about buying insurance. It's about financing risk. And insurance, i.e. risk transfer, is one tool that can be used to finance risk. So long term, clients are going to have to become more sophisticated about how they handle risk. And those clients that rebalance a blend of risk transfer, self-insurance, alternative options available, utilization of captives, are going to more effectively manage their total cost of risk down. And we can't think about cost of risk as just what we pay in premiums. It's what do you retain in terms of deductibles? What do you pay insurance premiums? What do you pay brokers? What do you pay other intermediaries? All of that makes up your total cost of risk. And we're going to have to develop a more sophisticated approach to managing the entirety of that cost.
Spencer Levy
Well I think that's a great way to frame it. For those folks that are on this, listening here, many of you know property and casualty insurance, for those of you that are not in the investment side of the business, know it from what you get for your home every day and you see your home insurance going up and say, what can I do about this? That's very different than what we're talking about here today. For home insurance, you could self-insure or you could not, and go to the marketplace. But in commercial, you have a variety of options. And this is a financial instrument that is one piece of the risk mitigation puzzle. Is that a fair way to summarize it all, Ryan, Raphael, Chris?
Raphael Dawson
Absolutely.
Spencer Levy
Well, that's the first time I've gotten something right on this show that quickly in the six years of The Weekly Take. And it comes from great guests like you, Chris, Ryan, and Raphael. And I can't thank you enough, all of you, for appearing on The Weekly Take today, starting with our own Chris Nassa from CBRE, who leads our insurance efforts. Great job, Chris.
Chris Nassa
Thank you, Spencer. Thanks for having me.
Spencer Levy
You bet. And then Ryan Barber, Global Property Leader for Aon. Ryan, thanks so much for coming out today.
Ryan Barber
Thanks for having me.
Spencer Levy
And then my friend Raphael, by the way, you're all my friends, but I’ve just known Raphael longer. Raphael Dawson, Senior Principal at Walton Street Capital, one of the largest real estate private equity firms.
Raphael Dawson
It has been a pleasure.
Spencer Levy
Before we sign off, we once again like to extend our hearts to the people of greater Los Angeles, whose lives were upended by the recent fires, and for that matter, to anyone who has been touched by natural catastrophe. As you rebuild, we hope this show helps you plan for the future. For more information and related content, please visit our website, CBRE.com/TheWeeklyTake. We'll post additional resources regarding not just insurance but also relief efforts and other ways to donate and contribute to the recovery. We'll be back next week and look forward to covering other timely and important issues for commercial real estate. Thank you for joining us. I'm Spencer Levy. Be smart. Be safe. And with love to L.A., be well.
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