Captive Insurance Solutions To Support Real Estate Risk Management Strategies

According to The Council of Insurance Agents & Brokers, commercial property premiums jumped 10.1 percent in the first quarter of 2024, representing the 26th consecutive quarter of increases.  While premiums for the commercial market have generally begun to stabilize, multifamily projects will continue to be hammered with hefty increases for the foreseeable future. 

Commercial property owners and investors are eagerly seeking ways to reduce their insurance spend while obtaining adequate coverage to protect their assets and comply with lender covenants. That has led many to explore the concept of establishing a captive insurance company.

Captives allow commercial real estate owners to enhance protection, increase their self-insurance opportunities, and customize their insurance coverage. In addition, they can benefit from underwriting profits that would normally go to their insurer, further reducing their overall spend. 

The nature of captives generally makes them less feasible for organizations with less than $5 million in annual premium volume. While that may seem steep or unfair, it's all about basic economic viability. A captive needs to be sustainable from a loss perspective. With property risk, claims are considered "short tail" and thereby pay out more quickly, requiring sufficient premium volume to sustain the captive's efficacy.

It's not unusual for an organization facing steep premiums to assume the captive strategy is the right answer, but moving to a captive insurance company isn't like simply flipping a switch. The process involves the organization's overall business strategy, financial strength, and leadership's appetite for risk.

Structuring a captive around any organization's current situation is less viable than building it around foreseeable strategic goals. If real estate investors expect their portfolio to grow significantly, plan to divest a substantial chunk, or shift into a new market or sector, their captive needs to reflect and accommodate those plans.

One of the most significant issues in the real estate arena involves the growing potential for catastrophic claims. If a portfolio includes properties in areas prone to flooding, wildfires, or massive storms, its fast-growing premiums reflect insurance payouts for previous catastrophic events. While some owners assume that refers only to coastal locations such as Florida and California, even inland states like Michigan are experiencing more large-scale wind-damage events.

Owners may be willing to assume the risk for catastrophic risks, but that doesn't mean a commercial insurer is going to share their enthusiasm for covering specific properties. Experienced captive consultants know which commercial insurers are willing to find mutually agreeable solutions, even if that means stepping away from the captive approach.

Captive consultants can perform optimization studies that provide realistic projections for losses, informing recommendations for the most cost-effective way to structure the program. They can help real estate owners determine the optimal level of deductible based on the expected rate of return on funds invested in the captive.

Optimization studies can also consider the impact of structuring deductibles in a series of tiers. In addition to an overall deductible, there may be separate deductibles for earthquakes, flooding, and so forth.

One of the biggest obstacles to forming real estate captives involves meeting the requirements of third parties such as lenders. Loan documents often require specific coverage amounts and deductibles, while captives are typically designed to pair with high deductibles in the early years of operations.

Another common covenant involves the requirement that property be covered by a company with an A.M. Best rating, which provides a hurdle, as most captive insurance companies are not rated. Additionally, some commercial tenants have their own requirements for coverage. As an example, one major retailer requires at maximum a $250,000 general liability deductible with an A-minus or better–rated insurer.

Captive professionals are familiar with multiple structures for addressing issues like these, whether it involves a comparatively simple indemnity agreement, structuring a captive in a fronted reinsurance program, or renegotiating complex leases to allow a captive's higher deductible.

One common risk transfer strategy when faced with a deductible restriction involves fronting, in which an insurer will write a policy and cede most or all of the risks to a reinsurer, in this case a captive insurer. The commercial insurer becomes known as the fronting company, receiving an agreed-upon percentage of the policy's premium and paying out losses in accordance with the shared percentage. The downside of fronting is that it does include paying additional fees.

Pursuing a captive insurance company is a change in business strategy that demands examining and funding risks in different ways. That's why it's important to consider your organization's strategic goals, whether that includes growing, acquiring, or divesting your property portfolio.

Captives are intricate structures that require professional planning, forecasting, and advice to achieve long-term success. Choosing an experienced captive adviser or manager gives investors and other owners access to knowledge about captive types, ownership and program structure, service provider guidance, and working relationships with insurers and other key players.