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Insurance Insights: The Circle of Storage

Scott Lancaster Comments

When it comes to real estate investments, the primary consideration is generally location. When you look to build or acquire a self-storage facility, you consult demand studies to maximize the occupancy and revenue of your investment at a given site. Property valuation is linked to occupancy and revenue, which in turn is linked to demand, which is a function of location. This is the great circle of business in self-storage.

In past articles, I’ve discussed the difference in between property valuation for the purposes of insurance vs. real estate. Insurance valuation focuses on the cost to rebuild or replace a property, which may be very different from its resale value. While the cost of reconstruction is influenced by location through such factors as the cost of labor, materials and building codes, the relationship is not nearly as strong as you find with real estate valuation. However, location can have a significant impact on the cost and even the availability of property insurance included in the consideration of every major real estate transaction.

Principles of Predictability

While the insurance and real estate industries look differently at location, hence value, the underlying reason for its importance is the same: the expectation of profitability at a particular site. The capital markets that form the basis of real estate and insurance transactions look at the expected return on capital and the relative security or risk of investments.

Investors will generally accept a higher risk on their capital investment for an expected higher rate of return. But with insurance, an investor’s willingness to accept a high level of risk must be tempered by the duty to avoid volatility that may impair the ability to pay promised proceeds to consumers. The importance of this duty to the insurance purchaser and the public is evidenced by the fact that insurance rates, capital reserves and financial stability are closely monitored by financial-rating bureaus and state and federal regulators.

What allows insurance to function as a business to transfer the financial risk of loss from an unexpected event is the predictability of loss that results from the aggregation of many independent but similar losses. An example is automobile insurance. None of us, individually, could predict numbers or outcomes of future accidents, but an underwriter knows the total number of car accidents that will occur over a large population of drivers is amazingly predictable.

This principle of predictability fails in areas subject to catastrophic risk. The risk is not very predictable, and the exposure to loss is not independent. A catastrophe in the property-insurance industry is a disaster (either manmade or natural) that is unusually severe and affects many people. An official catastrophe designation is given to an event that causes $25 million or more in insured losses and affects many policyholders and companies at one time.

As this article is being written, Southern California is in the process of cleaning up and assessing damage caused by a series of wildfires that broke out on Oct. 21, 2007. At the beginning of November, insured losses from these fires were expected to exceed $1.5 billion. Wildfires, floods, tornadoes, snowstorms and acts of terrorism all present catastrophic exposures that are difficult to predict and can create insured losses over a wide area, causing significant impact on insurance industry capital and threatening solvency to insurers with significant exposures in affected areas.

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