Your building’s replacement cost is $100 million and your property insurance limit is $500 million. Very secure, right? Not necessarily!
Risky property insurance plans are being sold in the marketplace with very little if any disclosure about how they actually work. Large numbers of properties owned by various unrelated entities are being aggregated by insurance brokers and covered under programs that leave the properties exposed in the event of an “unexpected” large event. For example, there are programs where $3 billion of property are subject to a “per occurrence limit” of only $500 million.
The contractual obligations have been flipped so that the risk of unexpected loss now rests with the insureds, not the insurers! The financial strength ratings of the insurers are prominently highlighted, but they are not the point in this case. The weak link is not the insurers, but the integrity of the program itself. Property owners and managers need to be aware of this dirty little secret in the insurance industry.
How it Works
In the traditional method you insure your building or portfolio of buildings for 100% of their replacement cost. The property insurance is dedicated to your property; that particular policy covers only your properties and the insurance limit is a limit that is fully available to cover your losses. Losses at properties other than yours cannot in any way impair your limit.
Under the new model, however, insurance brokers on their own or in conjunction with the large property managers are pooling together property portfolios of many unrelated owners into a single insurance program with a shared limit. These programs sprang up after Hurricane Katrina due to the fact that property insurance capacity dried up in catastrophe exposed areas of the country. As an emergency response these programs were creative and got the industry through the crisis. They never died, though, and in fact have become more and more prevalent since that time. Obviously the premium can be lower than dedicated coverage, and without full disclosure of the risks, dedicated programs don’t stand a chance in the competitive marketplace. Thus the new ones are being sold aggressively by hungry brokers.
These programs do have a logic behind them and they have a veneer of respectability because of the computer models that purportedly back them up. The concept is that the computer model can predict with good credibility the chance of the “per -occurrence limit” being exceeded by any single event. For example, though you may have $3 billion of property values exposed at a given time, and a per-occurrence limit of $500 million, the model projects that there is a low probability of any loss ever exceeding the $500 million.
Now It’s the Insured’s Risk
Notice who is now at risk. Under the traditional system the insurance company issues multiple separate policies to various insureds. Each insured is covered in full, but the insurance company risks the chance that it will have too much accumulation subject to a single loss, or even a series of losses, in a certain geographic area. Under the new shared limit programs, though, the insureds are the ones at risk. There could conceivably be $1 billion of losses with only half of that available to pay claims. To add insult to injury, the programs don’t even have an allocation formula in the event of a shortfall. Remind me again: who are the ones in the risk business?
The computer models are extremely suspect, particularly with respect to the inputs (“garbage in”). The data input with respect to each property in the program is so detailed – architectural/engineering specs, very specific construction methods, about 30 inputs in some cases that would be information not readily available to most insureds. Applications are often completed by insurance brokers, and the information is almost certainly “estimated.” The ones we have looked into in detail (comparing the model inputs to the building information they were based on) contained erroneous data.
The model is based on catastrophe exposure in relation to the total values at risk in the program. As the brokers sell participation in the program the total values are constantly increasing. The model was probably based on an initial estimate of total values and is not necessarily updated at frequent enough intervals if at all. Most times the model is not released if requested, with the statement that it is “proprietary.”
One plan we looked at didn’t even pass the common sense test. All values were on the west coast of Florida within a couple of hundred miles of each other. The limit “per occurrence” was 18% of total values exposed. There is no number of computer models sufficient to entice me into that program.
Geographic spread of risk is the necessary ingredient for success of these programs, a trait sorely lacking too often. In fact, the only way to independently evaluate the safety of the program is to obtain the location of all the properties in the program and their values, and to manipulate that to end up with total value by zip code. Not only do the proposals not contain this information, request it and you’ll run into a wall of silence.
How Relevant Are the Insurer Ratings?
The limit that is provided to the program is underwritten by insurance companies, usually multiple insurers each providing a layer until the full program limit is reached. The financial strength ratings of the insurers are prominently shown in the insurance proposals so that the prospect can see them and achieve a sense of security that the program is backed by big, strong players. In reality, the ratings fade in significance compared to the financial integrity of the program itself. The adequacy of the shared limit is the weak link in this scenario, and so the provision of insurer ratings is actually deceptive. Suffice it to say no one is providing a financial strength rating of the program.
Disclosure – What Disclosure?
We’re all adults and free to enter into any deal we want, right? (Assuming our lender is aware and goes along too; these programs will violate insurance covenants in most loan documents).
The question is: are we actually aware of what is going on. What does the disclosure look like in a) the proposal and b) the policy?
The proposal can have no disclosure or a very cryptic disclosure such as this one:
Program Limit of Liability & Coverages
Group Limits of Liability
LIMIT IS PER OCCURRENCE
Limit Coverage $500,000,000
Total limit as a result of any one loss, disaster, or occurrence – Real and Personal property including but not limited to Property in the Care, Custody or Control of the Insured, Business Interruption, Rental Value and Extra Expense, Incidental Course of Construction, Extended Period of Indemnity 365 Days, Leasehold Interest, Additions/Alterations, Ingress/Egress, Civil Authority, all as more fully defined in the policy form; except:
If you aware and on the lookout for this type of structure, you will know what this is. If you are just a typical property owner who has not seen one of these programs and does not know they exist, will it be meaningful to you? No, it will slip by unnoticed. What is really needed is: CAUTION – THIS IS A SHARED LIMITS PROGRAM – PLEASE CONSULT PROFESSIONAL ADVICE BEFORE YOU ENROLL.
Well, if you didn’t see it in the proposal, you’re not going to see it buried in the 150 pages of fine print that comprises the policy, are you? Enough said?
Where’s the Scandal?
Like the sub-prime mortgage market everything is fine until the inevitable happens. There are so many of these paper-mache programs in the market now that at some point a large storm will put one or several of them under water (in both ways), and the broker community will say “no one could have seen that one coming.”