S&P Global Ratings believes it would be helpful to provide further context about the effect of higher premiums on U.S. rental housing projects, and possible repercussions for credit quality.
Frequently Asked Questions
What are the credit implications of rising insurance costs?
Rising insurance expenses are unlikely to be the sole driver of a negative rating action in our rental housing bond universe. In our review of rated rental housing projects’ latest financial statements (mostly fiscal 2019), we found that actual insurance expenses averaged $558 per unit in fiscal 2019 compared with $330 per unit in fiscal 2015. This 60% increase can be addressed through strong management and governance expense control. However, when coupled with other rising expenses that are unable to be recouped through revenues due to occupancy strains, rising insurance costs can be a contributing factor to DSC weakening and, ultimately, rating pressure.
On average, across all rental housing subsectors, insurance expenses rose by an average of about 30% between fiscal years 2017 and 2019; similarly, in its April 5, 2021, Weekly Outlook, Municipal Market Analytics notes that the renewal rate increases for the sector were reported in April 2020 at approximately 33% by Marsh versus 23% in the broader real estate sector. We assumed insurance expenses continued a 30% increase over the next two years while all other expenses remained flat, and conservatively assumed no increases in effective gross income. In this scenario, about 90% of rated projects remained at the same coverage factor assessment as in our previous rating review, while 10% (13 projects) weakened by about one assessment level based on lower DSC (that is, moving from very strong coverage to strong coverage). For these 13 projects, it’s possible, but not certain, that the lower coverage factor assessment could result in a lower coverage and liquidity score and ultimately lead to a negative rating action.
In this 30% scenario, the largest decreases in DSC occur in the Section 8 and unenhanced affordable housing subsectors, averaging drops of 6 basis points. The mobile home park subsector appeared least affected, with an average DSC decline of 1 basis point.
What’s causing the increase in premiums?
In recent years, U.S. property/casualty (P/C) insurers’ profitability has been pressured by the prolonged low interest rate environment and a rise in extreme weather events. Typically, P/C insurers invest predominantly in investment-grade fixed-income securities, so the steady decline in rates has depressed the income generated by their large investment portfolios. This long-term trend has led insurers to increasingly focus on improving profitability in their underwriting operations to achieve return on capital targets.
At the same time, more frequent extreme weather and natural catastrophe events have increased losses for those insurers writing property coverage. In addition to more traditional loss activity from hurricanes, tornados, and hailstorms, the industry has had to contend with a surge in Western wildfire losses due to multiyear drought conditions. Insurers have also experienced losses from more unusual events like the Midwest derecho that devastated parts of Iowa and the freeze damage in Texas caused by the February 2021 winter storm that was exacerbated by the damage to the state’s electrical grid.
This heightened property loss activity has led insurers to seek substantial rate increases on both residential and commercial properties, particularly those in areas vulnerable to such events. In the past two years, pricing for commercial property coverage has risen substantially (chart 1). Based on the comments of insurance company management in their first-quarter 2021 earnings calls, pricing momentum remains strong. We expect that the commercial lines pricing environment will be strong for the rest of this year.
We have excluded pools of loans secured by affordable multifamily housing and focused on so-called stand-alone transactions, which include:
- Affordable multifamily housing (including mobile home parks),
- Age-restricted independent or assisted-living rental housing, and
- Privatized military housing projects.
How much have insurance expenses risen?
Insurance costs have risen for the vast majority of the public finance rental housing projects we rate. Although annual increases in operating expenses are common, insurance costs more than doubled between fiscal years 2017 and 2019 for 11 rated projects, most them Section 8 and military housing projects. The largest increases occurred at projects in the Midwest and South Atlantic regions.
Section 8 projects.
Average insurance costs for Section 8 projects rose to $548 per unit in fiscal 2019 from $244 per unit in fiscal 2015 (chart 2). Between fiscal years 2017 and 2019, insurance expenses increased by an average of 55% at smaller scale projects (typically fewer than 300 units), compared with the 64% average increase at projects with more than 300 units. For example, at a project consisting of 11 properties with 782 total units, premiums increased due to the vulnerable coastal location of some properties and the sustained damage to other properties from fires and other physical damage to the buildings. The owner expected these factors to keep insurance expenses elevated during the following two fiscal years, with a 110% increase on the insurance renewal date of March 18, 2020, to $1.1 million from $530,459.
Age-restricted rental housing projects.
Between fiscal years 2015 and 2019, average insurance costs rose to $666 from $115 per unit for age-restricted rental housing projects. In this subsector, rated organizations have increased from 2 projects in fiscal 2015 to 14 projects in fiscal 2019, which is partly driving the increase between 2017 and 2018. The largest increases in insurance expenses between 2017 and 2019 occurred at projects in Texas and Arizona, and that average more than 400 units.
Unenhanced affordable housing projects.
At some rated unenhanced affordable housing projects, insurance costs rose between fiscal years 2015 and 2019, while at others, they fell. Overall, per unit insurance costs rose less than they did for Section 8 and age-restricted projects, but still more than in the other subsectors. Average insurance costs per unit were at a high of about $514 per unit in fiscal 2019, up from about $332 per unit in fiscal 2015. The largest increases between fiscal years 2017 and 2019 exceeded 50% and affected projects were located on the Gulf Coast in Louisiana and Florida. Over the same period, three projects in California and Illinois reported decreases in insurance expenses between 18%-49%.
Privatized military housing projects.
Average insurance costs per unit at rated privatized military housing projects increased 29% to $554 in fiscal 2019 from $430 in fiscal 2017, following a slight decline between 2015 and 2017. In recent years, some rated military bases in coastal areas were hit by severe hurricanes while those in Midwestern states faced strong storms; in all cases, the owner reported costly property damage. These weather events and the resulting damages contributed to rising insurance costs at these bases; costs more than doubled for one of these projects between fiscal years 2017 and 2019.
Mobile home parks.
Between fiscal years 2015 and 2019, average insurance costs per unit for rated mobile home parks increased to $326 from $259, among the more stable trends compared with the other rated rental housing subsectors, and the lowest per-unit cost in fiscal 2019. Depending on the location of these projects, we have applied adjustments in our market position assessment to account for environmental risks, which could translate to higher insurance costs. For one project, we applied a negative adjustment to the market position assessment based on our expectation of local economic trends, which could be pressured by increased insurance expenses, due to the project’s location in California.
How have higher premiums affected the public finance rental housing bond sector?
How we consider insurance in our analysis.
Our analysis considers the presence of property, general liability, and (where relevant) flood and earthquake insurance. We may apply a negative adjustment to the initial market position assessment if we identify the presence of material environmental, seismic, or construction risks; the level and quality of insurance coverage may partially mitigate such risks. Beyond this adjustment, we consider insurance expenses in our coverage assessment, based on a project’s debt service coverage (DSC), which can strengthen or weaken for a variety of reasons. When operating expenses rise faster than rental income and other revenues, a decline in net cash flow can make DSC inconsistent with the rating.
Our market position assessment accounts for 20% of the anchor rating in our analysis, and the coverage and liquidity assessment accounts for 50% of the anchor before any overriding factors or other adjustments. Therefore, decreasing DSC may pressure the coverage factor, leading to a credit risk.
Rising insurance costs are becoming a bigger part of properties’ performances.
In most cases, insurance costs represent no more than 10% of a project’s operating expenses, usually with higher percentages of the total composed of maintenance and repair, administrative, and personnel items. Despite their limited magnitude, insurance expenses now represent a larger portion of operating expenses than they had in past years, particularly for rated Section 8 and age-restricted rental housing projects (chart 3). Expenses at age-restricted properties are typically much higher than those at other affordable rental projects due to labor and other costs of care, so it is not surprising that insurance represents a smaller component than in other property types. At the high end, insurance expenses at two Section 8 projects represented close to 20% of total operating expenses in fiscal 2019 after they more than doubled in the previous two years. For rated military projects, the ratio of insurance expenses to total expenses has been relatively stable in the past five fiscal years, largely because of the simultaneous rise in maintenance and personnel costs.
Environmental Factors Likely Will Keep Pushing Costs Up
Insurance expenses are on the rise for the public finance rental housing sector, with only a minority of rated projects saving on this item in recent years. Insurance remains a relatively small part of rated public finance rental housing bonds projects’ total operating expenses, but average costs per unit have increased for all rated property types and are mostly due to environmental risks to properties’ locations. The magnitude of these increases might diminish their direct effect on potential rating movement, but some projects’ coverage factors could weaken (albeit relatively slightly) if insurance expenses increase by at least 30% in the next two years. As we review project performance, we expect to focus on insurance coverage and costs for rated projects, among other key credit factors, given their susceptibility to external risks, particularly environmental considerations.
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