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By Randy Sadler, CIC Services
In the high-stakes world of commercial real estate investments, where fortunes rise and fall with each transaction, there’s a critical element that can make or break financial decision-makers: risk management. For professionals like you at the helm of real estate businesses, understanding the profound impact of risk management isn’t just a matter of choice—it’s an absolute necessity.
To illustrate this point, we’ll look at an example from a prominent real estate development company, known for its office park projects, that was on the verge of completing its latest venture. Having invested substantial resources, the company had diligently acquired business interruption insurance and coverage for natural disasters, believing they were well-protected against unforeseen events.
However, when an unprecedented natural disaster struck the region, causing extensive damage to their prized project, the real estate company’s confidence in their insurance coverage was shaken. While they had indeed secured insurance, a critical gap in their policy became painfully evident. The damage-related losses far exceeded the limits set by their policy, leaving them with substantial out-of-pocket expenses.
This unforeseen financial burden not only strained the company’s resources but also resulted in months of costly delays in project completion. The company’s profitability was severely undermined, and their reputation, built over years of successful developments, took a significant hit as eager buyers grew frustrated with the delays.
This real-world scenario serves as a stark reminder that even established real estate businesses can face immense challenges when insurance coverage doesn’t align perfectly with their risk profile.
If you’ve found risk management, and more specifically, procuring the right insurance, a challenge, you’re not alone. Here’s why.
The Unique Risk Profile of Commercial Real Estate Businesses
As you’ve likely found, real estate businesses are exposed to a distinctive set of risks that set them apart in the world of finance and investment. Unlike some industries, real estate’s value is often tied to physical assets and market dynamics, making it uniquely vulnerable to a variety of threats. Consider these statistics:
- According to the National Oceanic and Atmospheric Administration (NOAA), the United States experienced 18 separate billion-dollar weather and climate disasters in 2022, including hurricanes, wildfires, floods and severe storms, all of which can impact real estate properties.
- The legal landscape can be treacherous, with real estate entities facing an array of potential liability claims. A study by the U.S. Chamber for Legal Reform found that small businesses’ total tort liability in 2018 was $182 billion, of which only 40% was covered by insurance. That means that those businesses paid an aggregate $109 billion out of pocket for those liabilities.
- Economic volatility, a constant companion in the world of real estate, can lead to significant fluctuations in property values, affecting rental income and investment returns.
- Environmental concerns are on the rise, and real estate businesses face increased scrutiny and potential regulatory fines due to pollution, contamination and hazardous materials.
- Vacancy and non-payment issues can significantly disrupt cash flow. During the COVID-19 pandemic, retail and office space vacancies surged, posing financial challenges for property owners.
Given these current events, the difficulty in preventing or mitigating the risks goes back to the example provided with the luxury condominium project: Not only are risks intensifying, but the risks are complex and evolving, which makes them difficult to adequately insure against within the traditional commercial insurance market. The insurance policies are not customized and, therefore may have gaps or exclusions, leaving companies exposed. It can also be costly and difficult to procure.
As reported by Barron’s, a 2023 report published by Moody’s Investors Service found the convergence of inflation and a surge in natural disasters has resulted in a noteworthy uptick in insurance, utility and operational expenditures within the realm of commercial real estate. The escalation in insurance costs can be attributed to the growing frequency and severity of natural disasters. In some instances, insurers have even withdrawn from specific markets, leaving commercial borrowers in those regions with limited and costlier choices.
Addressing the Risk Management and Insurance Challenges
Given this conundrum, the outlook for businesses that fall within the real estate industry is not dire–but effective risk management does require a more customized and comprehensive approach that addresses the complex risk profile that businesses like yours may face. This includes having procedures and training in place to prevent risks from coming to fruition in the first place, developing continuity and risk mitigation plans, maintaining compliance and regulatory adherence, and a tailored insurance program that fills the gaps in your traditional commercial insurance policies combined with cash reserves to weather the storm.
Empowering Commercial Real Estate Businesses with Captive Insurance
One growing trend to consider that offers policies customized to the distinct risk profile of the company is captive insurance. Captive insurance is a strategic risk management tool that empowers real estate businesses with a personalized approach to protection. Unlike traditional insurance, which often offers one-size-fits-all policies, captive insurance allows real estate entities to craft bespoke coverage that precisely targets the industry’s specific vulnerabilities, such as property damage from natural disasters, liability claims and economic fluctuations. By retaining a portion of the risk themselves, real estate companies gain more control over their insurance programs, ensuring that coverage aligns perfectly with their risk profile and business needs.
Additionally, captive insurance fosters cost-efficiency, potentially leading to substantial premium savings over time, a crucial benefit for real estate businesses seeking to maximize profitability in a volatile market. This cost-effective approach not only protects their investments but also amplifies profitability.
Moreover, captive insurance offers real estate entities enhanced control over claims handling, underwriting criteria and policy terms. This flexibility allows companies to adapt swiftly to evolving risk scenarios, ensuring business continuity even in the face of unforeseen challenges.
Protection Moving Forward
Risk management is not a choice but a strategic imperative for real estate businesses. Your unique risk profile demands a comprehensive and proactive approach to safeguard your investments and ensure business continuity. A good place to start is with a risk assessment and insurance review. It will help you pinpoint the risks your business is most likely to face while also analyzing where your business is uninsured or underinsured to fill these gaps that leave your business exposed. By adapting to changing market conditions, embracing innovation, and implementing effective risk management strategies, real estate companies can not only navigate the complexities of this sector but also thrive, contributing to the ever-evolving landscape of real estate for years to come.
About the Author
Randy Sadler started his career in risk management as an officer in the U.S. Army, where he was responsible for the training and safety of hundreds of soldiers and over 150 wheeled and tracked vehicles. He graduated from the U.S. Military Academy at West Point with a B.S. degree in International and Strategic History with a focus on U.S.–China relations in the 20th century. He has been a principal with CIC Services, LLC for seven years. In this role, he consults directly with business owners, CEOs, and CFOs on the formation of captive insurance programs for their businesses. CIC Services manages more than 100 captives.
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