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, Ive 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 investors 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.
When it comes to catastrophes, there is very little that can compare in severity to the damage caused by a hurricane. Nine of the 11 most expensive disasters in U.S. history were caused by hurricanes. In 1989, Hurricane Hugo resulted in $6.6 billion in insured-property claims.
The two catastrophes that were not the result of a hurricane were the Northridge earthquake of 1994, which caused $16.5 billion in property loss, and the Sept. 11 terrorist attack, which caused property losses of $20.7 billion. Catastrophic losses from Hurricane Katrina in 2005 are estimated at between $40 and $41.5 billion. To put these amounts in perspective, according to information gathered by the Self Storage Association, gross revenues for the U.S. self-storage industry in 2006 were approximately $22.6 billion; the total capitalization value for the entire industry in the United States was approximately $220 billion.
The profit from years or even decades of an insurance companys operations can be wiped out by a single hurricane or series of large losses. According to the Insurance Information Institute, the rate of return on net worth for insurance companies writing homeowners insurance in Florida was about 25 percent for 1993 to 2003. From 1990 to 2005, the rate of return on Florida homeowners insurance was -38.1 percent. Not an acceptable rate of return!
There are many different methods of spreading financial risk from catastrophic exposurebeyond the limited reserves of the direct property insurance market. Among them are private-market reinsurance; government-sponsored reinsurance such as the federal backing provided by the Terrorism Reinsurance Act; direct state and federal risk-transfer programs such as the federal flood-insurance program; and state-sponsored FAIR plans for fire insurance. These all represent different mechanisms to pick up part or all of the catastrophic risk the primary insurance market is not willing or able to absorb.
If an insurance company is not able to transfer a certain portion of risk due to catastrophic exposure, it may restrict the amount of business it will accept in disaster-prone areas to minimize the number of large losses it may suffer. This is why property owners in some areas of the country, particularly along the eastern seaboard and Gulf Coast areas, are finding insurance difficult and expensive to secure.
Disaster losses are likely to escalate in the future. People want to live on coasts or in the country or mountains, despite the unpredict-ability of natural disasters. Increased development in these areas means more potential loss from a single event. Although improvements in building codes and fire-protection equipment help control losses from individual fires and storm damage, these measures are not nearly as effective at reducing or eliminating the effects of a firestorm, tornado or Category 4 or 5 hurricane.
To be successful in self-storage, your business must be where people work and live, but dont overlook the importance of the availability and affordability of insurance. Work with your agent to determine in advance any special considerations of your proposed location. Some areas might create a high risk of loss, reflected in a very high rate, or a problem locating an insurance carrier acceptable to you or your lender.
A quarter-mile in any direction might make all the difference in flood-plain rating or brush-area concern and raise insurance costs that inevitably put a damper on other operating expenses. If you open a facility near a population center on the Atlantic or Gulf coasts, for example, you may find the cost or availability of insurance much improved by moving just a few miles inland.
In some respects, self-storage and insurance are not so different. Location plays a role in both. Understanding its importance before purchasing a business and seeking insurance will save you from going in circles and, instead, keep you in line with your goals for success.
Scott Lancaster started his insurance career in 1976 as a licensed insurance agent and broker in California. He is now the regulatory compliance officer for Deans & Homer, where he was hired as a commercial lines property and casualty underwriter in 1985 and has worked in the self-storage division since 1993. Deans & Homer has been providing insurance products designed to respond to the unique risks of the self-storage industry since 1974. For more information, call 800.847.9999; visit www.self-storage-insurance.com.