By George P Flanigan, MBA, CPCU
and IMS Elite Expert
BullsEye Bulletin: June 2009
The widely reported correction phase of the worldwide economy, and
the real estate sector in particular, is well underway. In the capital
markets, asset-liability term mismatches have yielded widespread decreases
in asset prices similar to the savings and loan crisis of the late
1980s. The property-casualty insurance market has also been affected.
During
the past decade, insurance companies enjoyed economic windfalls from periods
of inflated insurable interest in both commercial and personal lines. In
the commercial lines sector, business policies were often issued with unrealistic
projections for insured asset and revenue exposures. As price levels have
fallen dramatically, property-casualty insurers have seen an evaporation
of the abundant underwriting cash flows that occurred earlier this decade.
Financial Valuation and Property-Casualty
Insurance Negotiation
There are numerous parties, including mortgage, real estate, and financial
professionals, involved in real estate investment decisions. Price levels will
be determined by a variety of factors, including but not limited to market
metrics, cost of capital, and expected cash flow. Typically, insurance policy
placement will rely on price levels determined in these negotiations. Likewise,
claims negotiations will rely on representations from both financial valuation
and insurance underwriting discussions.
In addition, insurers are often ill
equipped to develop independent financial valuations in the negotiation process
and will rely exclusively on valuations provided by the client. After all,
higher valuation leads to greater insurable interest on which to develop premium
levels.
Similarly, in the claims settlement process, many claimants may underestimate
settlement proceeds based on inappropriate expectations of replacement
costs based on real estate market data. During settlement, it is extremely
important that expectations should not be developed according to real estate
markets but rather according to strict interpretations of relevant policy characteristics.
In the personal lines segment, the primary subprime exposure would
be the first-party variety. For example, a house purchased in 2005
for $300,000 (and subsequently insured with a typical homeowners policy
at that representation) in a region suffering price-level declines
could remain insured at 2005 price levels. From a pure underwriting
perspective, this creates an opportunity for insurers to continue collecting
inflated premiums on property values that far exceed potential claims
that insurers would be obligated to pay; hence, an “over-insurance” problem.
In economics, this is an example of moral hazard; insurers have little
incentive to adjust insurable interest based on price level.
Assuming similar properties are available through foreclosure or liquidation,
it is reasonable to conclude that current replacement cost would be
far less than the initial purchase price. Since construction costs
have decreased widely, it is logical that claims settlements will not
recover the original purchase price, or even outstanding mortgage obligations.
The losses will be realized by the claimant and the mortgagor failing
to recover full principal; the claimant, or first-equity holder, will
realize initial losses, which usually includes down-payment and other
sunk costs.
Further, mortgage stipulations pertaining to settlement management
may further limit claimants’ opportunities to maximize economic value.
The role of mortgage servicing firms should not be ignored since they
may be contractually entitled to negotiate directly with claims administrators.
An appreciation of individual circumstances is important, as mortgage
holding companies may hasten claims resolution to the detriment of
policyholders. Banks facing liquidity problems are inclined to recover cash
proceeds sooner. Insurers may participate, too, due to lower claims costs,
and policyholders ultimately pay for insurance they never collect, regardless
of actual loss activity.
Indeed, policyholders have purchased far more
coverage than they likely would recover in hypothetical claim scenarios.
This is in stark contrast to co-insurance clauses designed to penalize insureds
for under-insurance problems. Claimants facing ongoing settlement negotiations
with co-insurance applications should strongly evaluate claims administrators’ assumptions
pertaining to financial valuation and coverage application.
The over-insurance phenomenon is even more pronounced in business insurance;
builders’ risk policies, liability wrap-ups, property and business
interruption, and other business policies were commonly issued at inflated
insurable interest during the subprime boom.
Given the optimistic expectations of many real estate projects, financial
projections from recent years will prove entirely unrealistic in many
cases. These optimistic forecasts were likely submitted to commercial
insurance underwriters during the underwriting process.
In particular,
Business Interruption (or time element) coverage may be problematic
for commercial underwriters. Specifically, the “BI Period,” or
period of recovery to re-establish prior operations, may prove highly
judgmental in claims settlements. Important considerations include when cash
flow became impaired, and how much lost cash flow is realized, and when claimants
will return to expected cash flow levels. Arguments will likely be
presented that claimants will never achieve operating levels as
depicted to underwriting, and thus should be entitled to maximum policy
limits under Business Interruption policies.
Real estate ventures were
commonly introduced with optimistic cash flow expectations in mind.
For instance, an overly optimistic cash flow presentation made to underwriters
in 2006 may be entirely unrealistic when a project comes to market
several years later amid weak credit markets.
Property losses would not only
affect alleged recovery periods but would also affect projected cash
flow levels; thus, losses associated with real estate ventures would
be realized much sooner than otherwise.
Interestingly, mortgagors may experience
moral hazard in that insured property losses will permit loss realization
sooner than otherwise under normal GAAP accounting treatment. For instance,
mortgagors may prefer post-fire loss reserving rather than uncertain
foreclosure accounting treatment since expected losses may be realized
sooner. Creating perverse incentives such as this is not an intention
of typical insurance transactions, but insurance history is replete
with similar examples; notably in life insurance, where the interests
of the benefactor may differ from those of the policyholder.
“Master” condominium
association policies reflect another nexus of inflated real property
values. Starter condos were developed in many locations for $400,000
or more during the boom; thus, condominium association master policies
were underwritten with a collection of fully occupied $400,000
properties in mind. A brief review of corresponding financing arrangements
will likely reveal unrealistic developer intentions regarding future
appreciation of condominium property values as well.
An interesting
form of damages includes “collateral foreclosure damages,” or
loss of use value related to foreclosures in neighboring properties.
In particular, grievances between condo owners and association managers
will emerge when association managers suffer property damage related
to vacant properties. A reasonable argument should be presented that but
for negligence in the financing process, collateral damage related to foreclosure
damage would not have occurred and the property would have been valued
accordingly.
Commercial General Liability (CGL) policies apply to damages
pertaining to bodily injury and property damage. Elsewhere, liability related
to willful managerial wrongdoing would fall under “wrongful acts” provisions
on professional and management liability policies. However, when allegations
of negligence are presented against various parties in real estate
transactions, and such allegations have proximately led to third party property
damage (i.e. liability for collateral foreclosure damage), one can potentially
trigger application of CGL policies. Furthermore, collateral economic damages
would fall under vintage CGL policies on an occurrence basis.
Damages associated with the “over-insurance” problem
would be estimated as follows:
Document review for determination of underwriting factors provided
over disputed periods. This would be based on reported insurable
interests used in actual underwriting processes.
Adjust exposure base to reflect realistic property values according to
housing price corrections over the relevant time period. This exercise
establishes hypothetical property values at certain times, in absence
of overly-inflated housing prices amidst subprime financing. Scrutiny
of coverage terms along with financial analysis should be necessary
to determine hypothetical claims recovery levels.
Reconcile hypothetical property values to determine accurate exposure
levels that should have been used for underwriting purposes.
Apply actual rates charged to hypothetical adjusted exposure base. This
should yield an adjusted hypothetical premium charge in absence of
overly inflated property values.
These arguments can be presented to insurers either during claims settlement
negotiation, class action litigation, and other legal venues. However,
frequent episodes of high vacancy commercial property implies that
these arguments can be used in wide varieties of insurance transactions,
including but not limited to bankruptcy proceedings. Indeed, the subprime
aftermath should present wide varieties of potential applications for
some time.
About the author: George P Flanigan is a consultant based out
of Chicago and an IMS Elite Expert. His prior work experience includes business
analysis and underwriting with both American International Group and Zurich-American
Insurance Company. George holds a Master in Business Administration
from the University of Chicago Booth School of Business with concentrations
in Finance, Accounting, and Entrepreneurship.
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