February 27, 2003

Insurance industry weathers a ‘perfect storm’

Real estate players reel from the aftermath

By SCOTT B. OSBORNE
Preston Gates & Ellis

Osborne
Osborne

The magnitude and unpredictability of the tragic losses of Sept. 11, and the belief that similar losses might occur again, have forced lenders, landlords and tenants to retain risks previously shifted to insurance companies.

The cost of insurance has increased dramatically and, in some cases, the inability to economically insure risk has prevented deals from happening.

Total insurance claims — life insurance, workmen’s compensation, property damage and business/rental interruption — from 9/11 will be about $40 billion. These were not the only losses suffered recently by the insurance industry.

In 2001, natural disasters also took their toll. Perhaps most significantly, there were “asset value” adjustments to the insurance industry balance sheets (aka stock market losses) that resulted in a $100 billion-plus reduction in industry net worth. These all combined to create the “perfect storm” for the insurance industry.

Taking measures

The insurance industry response has been immediate and three-fold.

First, the industry, particularly re-insurers, excluded terrorist losses from property damage and liability policies. Next, the cost of insurance has been raised to a level that reflects not only the probability of loss, but also the total financial exposure of the insurance company. Finally, the industry sought federal relief in the form of a federal re-insurance program for terrorism losses.

The first two of these strategies had a dramatic effect on the real estate industry.

Prior to Sept. 11, the typical property damage insurance policy excluded acts of war, nuclear explosions, earthquakes and floods. There were special policies available at extra cost to cover earthquakes and floods. “Terrorism” was not excluded, however, so losses arising from terrorist acts were covered.

Post Sept. 11, the insurance industry began to treat “terrorism” in the same manner as earthquakes and floods. For an extra premium, limited coverage for terrorist acts could be obtained. However, the cost for coverage similar to what existed prior to Sept. 11 was simply uneconomical.

While this created severe problems for some projects, particularly in New York City and Washington, D.C., the effect on projects in the Puget Sound area was negligible.

The exclusion of terrorist acts from standard property damage policies divided the real estate finance market into two segments.

The “securitized” market — loans originated and then sold on Wall Street as commercial mortgage backed securities (CMBS) pools to investors — has been the most inflexible. Servicing agents, fearful of liability for failure to adequately protect collateral and responding to rating agency concerns, have insisted that borrowers obtain terrorist coverage no matter what the cost. This has lead to some high-profile lawsuits by borrowers, such as the owner of the Mall of America, contesting the right of the lender to demand extra expenditure for terrorist coverage. The outcome of these disputes has turned upon the specific wording of the insurance clauses contained in the mortgages.

Lenders that hold mortgages in their own portfolio, such as life insurance companies or commercial banks advancing construction loans, have been more flexible in reaching an economical solution for terrorist risks. This has become a marketing tool for some portfolio lenders. Borrowers that calculate the total cost of a mortgage transaction might conclude that the flexibility of a portfolio lender on the requirement for terrorist coverage may be worth significantly more than the savings from a slightly lower CMBS mortgage rate.

As insurance costs have risen, tenants are paying closer attention to lease clauses to determine whether the landlord has the right to pass through the increased costs. Landlords face not only resistance by tenants to increased costs, but also have to deal with the overall market.

In markets with significant vacancy rates, increased insurance costs have squeezed landlords’ operating margins since the full cost increase cannot be passed through to tenants. This is particularly true in the Puget Sound apartment market, where landlords face increased insurance and other operating costs, stagnant rents, and have a more limited ability to pass these costs through to their tenants.

The third prong of the insurance industry strategy was achieved earlier this year when the Federal Terrorism Act was signed into law. This legislation provided a federal backstop for terrorist losses in exchange for the requirement that all insurance companies must offer coverage for terrorist acts.

Although the legislation does not require coverage be offered at commercially reasonable rates, initial indications are that rates for terrorist coverage have declined for most portions of the real estate industry. High-profile projects in New York City still face high rates for terrorist coverage, but for projects in the Puget Sound area, the federal legislation has had a beneficial impact on costs.

Local impacts

As a result of the exclusion of terrorism risks, participants in real estate transactions have become more aware of the fact that there are a variety of risks not covered by insurance.

In the Pacific Northwest, real estate owners are most familiar with earthquake exclusions. There are now exclusions for losses from hazardous materials, mold, mildew and water intrusion.

In the Seattle area, the impact of water intrusion losses has had a far more significant impact on multi-family developers than any terrorism exclusion. Some contractors have been unable to obtain insurance required by owners, and in those instances in which insurance was available, the cost has significantly added to the per unit cost of the development.

The contractor’s insurance program has become an important feature of the ability of the contractor to compete for multi-family projects.

The impacts of 9/11 accelerated the trend of insurance companies to exclude a wider array of risks faced by parties to real estate transactions. Real estate investors have had to assume previously covered risks and pay increased costs for insurance coverage that is available.

Participants in transactions have also been required to spend additional time and cost in properly allocating the risk of loss for those items previously insured. This has occurred just as real estate has entered a cyclical downturn in the Puget Sound area.

The ability to obtain insurance and the price paid for coverage has become a significant factor in the ability of developers, lenders and tenants effectively compete in their respective segments of the real estate industry.

Scott Osborne is a partner in the Seattle office of Preston Gates & Ellis LLP and a member of its real estate practice group. He focuses on providing counsel to participants in real estate transactions. He can be reached at scotto@prestongates.com.

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