Basics of Property Direct and Facultative Insurance
Much like our own homes, commercial property faces a number of different risks and it’s important to ensure that suitable insurance is taken out to protect against them. While sharing many similarities with residential insurance, commercial property insurance is a type of specialty insurance which has a number of key differentiating features. In 2020, the UK commercial property insurance market was valued at close to £7bn.
Features of Commercial Property Insurance
Commercial property insurance is a short-tailed line of business, with claims usually reported and settled shortly after being incurred. A commercial property insurance contract will typically insure against two things; property damage and business interruption.
Property damage covers the insured against the cost incurred at the hands of perils such as fire, floods, natural disasters, and theft. Business interruption will cover the insured against losses incurred from being unable to carry business out as usual.
For example, a factory fire might see a claim against the cost of repairing the factory, plus the lost revenue from being unable to make & sell products.
What is Direct & Facultative Insurance?
Direct simply means that the insurance is placed directly with the underwriter, and facultative means that the insurance is taken out only on a specific set of risks.
The alternative to facultative insurance is the treaty approach, whereby a reinsurer agrees to take on a proportion of the risk attributable to a large group of policies. A treaty approach will typically also cover any new business written by the insurer, provided it matches the risk profile outlined in the original treaty.
Under a facultative approach, the insurance covers only specified risks at a specified property – e.g. ‘Risk of fire at APR Towers’. Unlike a treaty approach, a further policy will need to be taken out for any additional property or any extra risks that the company wishes to indemnify itself against.
Facultative insurance allows the insurer to tailor the insurance to the risks present. This can benefit both the insurer and the insured. The insurer is able to carry out detailed modelling in order to price the policy to closely match the risk, while the insured benefits by not having to pay for insurance against risks that are not relevant to its business.
Implications on Commercial Property
As commercial property is a more specialist type of insurance, with wider variations between different properties than for residential insurance, it makes sense for commercial property insurance to be facultative.
Given this, the next question is: what factors should be taken into account when pricing such a policy? There’s certainly no shortage, and a better question might be ‘how many factors are too many’!
A very limited list of example factors is below – each will impact at least one of the frequency and severity of claims:
- Value of property
- Type of business conducted at the property (is it a fireworks factory?)
- Age of building
- Location of building (is it in a location prone to earthquakes / hurricanes / floods?)
- Fireproofing measures (is it made exclusively of wood)
Models may also incorporate the Maximum Feasible Loss (MFL). This represents the largest loss the insurer would expect for a given risk. For example, if a large distributor has five warehouses on its site, all of which are separated by roads, then the insurer may not expect a fire in one warehouse to spread to another. Therefore, the MFL for fire risk would be the cost of rebuilding one of the five warehouses rather than the entire complex.
The Effect of Covid-19
The Covid-19 pandemic has resulted in some large changes in how commercial property is being used, particularly in large commercial hubs such as London. The rise in remote and hybrid working has reduced the demand for commercial office space.
Unoccupied buildings are at far less risk of internal damage: machines can’t break or cause fires if they’re not being used. However, it’s not true to say that all risk has been reduced. Break-ins and arson are more likely to happen to empty buildings, and incidences of these may be more severe as they may not be noticed promptly. By taking a facultative approach to commercial property insurance, underwriters can tailor their products to the specific risks facing a particular business.
Also, the Covid-19 pandemic itself has had a large impact on business interruption insurance. In facultative property insurance, the business interruption insurance policy would only pay out if the interruption was caused by a peril covered by the associated property insurance policy.
As property insurance generally only covers physical perils, most facultative property insurance policies did not need to pay out due to interruptions caused by lockdowns. However, often whether a property insurance policy covered business interruptions due to Covid-19 would be due to the exact wording of the policy.
Insurers are likely to specify this more carefully in the future, with pandemic coverage becoming its own area of insurance in the wake of the coronavirus epidemic. However, covering pandemic related interruptions causes its own set of problems – risks across an insurer’s portfolio are going to be extremely strongly correlated.
Other Recent Developments
Even before this, the market for commercial property insurance was changing. In previous years, insurers focused on writing more business, even if it was less profitable, but in 2019 there was a sharp uptick in rates, with premiums increasing by over 10% on average.
This was partly driven by a number of costly natural catastrophes in 2017 and 2018, such as Hurricanes Irma and Maria in the USA alongside poor investment returns resulting in a so-called “hard market”. Insurers are more concentrated on profits and only willing to write business that they are very confident will make money.
This reluctance to write business has facilitated the rise of facultative insurance: it is much easier to model a small number of particular risks than try to estimate the chances of damage/business interruption for any reason. Another similar beneficiary of the hard market is parametric insurance; you can read our article on it here.
Commercial property insurance remains a large sector of the insurance industry, but is currently in a very hard market. Previously, insurers competed over properties to insure, often at unprofitable rates, hoping to turn a profit on investment returns and secondary products. Only recently have they started to be much more focused on direct profitability rather than expanding their customer base following a number of climate change related natural catastrophes and economic uncertainty.
To combat this, insurers have focused on products where they have more control over the risks covered like facultative insurance, which makes it easier for insurers to quantify the likelihood and financial cost of damages.
The commercial property market will continue to evolve in the future. The treatment of extremely correlated pandemic risks poses a threat to commercial property insurers and reinsurers as the demand for this type of protection increases. Indirect effects of Covid-19 like the rise in empty office buildings also provides a challenge for insurers as the risks to these buildings changes hugely depending on whether or not they are occupied. Climate change and the high inflationary economic environment pose different challenges to insurers as well, causing more frequent and more costly claims than predicted at the outset of policies. These problems aren’t transient, and whether the commercial property market will soften or remain hard in response to them is extremely hard to predict.
Jack Foley and Thomas Pycroft