Yesterday I shared how low interest rates and low bond yields create counter-party risk. What is good for borrowers is bad for lenders. Today I’ll discuss how lenders pass that pain off to everyday Canadians, with some sad stories about rising insurance causing real suffering to normal people. 

 

I owned 4 rental townhomes in a 59 unit self-managed strata that has some aluminum wiring. They have been a good investments for the past few years, seeing good appreciation. This strata saw premiums increase from $19,000 last year to a whopping $150,000 this year on renewal. The council members are not business people and most are retired or still woking, and they followed the bad advice of an insurance broker saying it was either buy this $150,000 policy, or rewire the entire complex. A rewire wasn’t feasible because initial estimates for a complete rewire was $3.5M. Strata council ended up buying this expensive policy in a panic, resulting in a $130,000 budget deficit.  Paying for this 790 percent insurance increase means upping monthly strata fees by $200, and this is a hardship for many of the owners who are on fixed incomes, and who don’t have the luxury of selling like I do. 

A solution has since been found to obtain $40,000 insurance by pig tailing the aluminum wiring, but not without paying a $75,000 penalty to break free from the old insurance policy.  The volunteer strata has since been replaced by other owners angered by this mistake.  I have lobbied the other owners to hire a professional management company to avoid mistakes like this in the future.  This one mistake of buying the wrong insurance could have paid for a decade of professional property management services with experience in negotiating large contracts.  Since these owners are pennywise and pound foolish. I think they will continue with self management with this new strata. I did try to educate this group of owners, and I served on strata council when I first bought these units, but I found I was outvoted too often so I didn’t seek reelection.  All but one townhome is now sold, and I am working to sell the last one this year, not because of the aluminum wiring and insurance issue per se, but instead so I can realize significant gains, and to break ties from this group of owners who are penny wise and pound foolish.

As an apartment building owner, I am also seeing premiums increase significantly across the portfolio, in one case about 5x higher on renewal, and we’ve had more than a few stressful renewals where looking for any insurers willing to underwrite the risk at all. I am also seeing deductibles so high in the apartment building space that I would never make a claim except in the case of a catastrophic loss. In many cases deductibles are no longer zero or in the 10s of thousands of dollars, but instead in the 100s of thousands.   Suddenly, prudent business practices require a much larger contingency reserve on hand  than in previous years,  that is cash sitting idle in the bank,.

- I count myself and my shareholders lucky compared to real estate operators in other segments of the market. My insurance broker told me that I’d be shocked to learn that the majority of hotels during the pandemic were uninsured.  Revenues were zero thanks to lockdowns, and with costs up so high the only choice for some owners was to roll the dice and be uninsured.  This would cause a default on any mortgages on these hotels, and it’s a wonder we haven’t seen a wave of hotel foreclosures yet. I know of retail locations and hotel owners who have seen revenue slashed during the lockdowns, and these rising insurance costs are yet another headwind they are facing. Hopefully things turn around for them in a big way once things fully reopen.

If you read news articles on the topic, and I’ve linked some of these articles in the show notes, you’ll see skyrocketing insurance is hurting a lot of people.

The huge increases in insurance premiums is partly to blame on regulations that ironically are designed to protect consumers. Insurance companies in Canada must follow rules that restrict them from investing in what regulators regard as riskier investments. The idea is that insurance companies should have plenty of liquid investments where the principal amount is safe that they can easily convert to cash to pay out claims.  So, insurers are forced to invest heavily in bonds, which unfortunately have been yielding negative nominal interest rates  .   

Failure to maintain enough enough investment bonds results in intervention by OSFI, and so for years up to half of an insurance company’s investments have been in low or negative yield bonds.  Compounding this problem, there have been more claims in recent years due to natural disasters, think of the all the floods and fires in the news recently.  In short, profits are down, and insurers have acted in lockstep to increase premiums or drop customers altogether. Consider this.

- Aluminum wiring in Canada is not actually very risky, there is a simple fix. A problem occurs if the electrical fixtures are changed repeatedly as will happen in an aging building when they wear out or styles change. The aluminum wire becomes fatigued when repeatedly manipulated, and the metal fatigue can increase the electrical resistance, causing the risk that the wire can heat up, potentially increasing the risk of fire. A simple exam of the building with a handheld FLIR device can identify any hot spots, and the issue can be permanently fixed inexpensively by pig tailing every electrical device. This involves using a marrette and lubricant between the original aluminum wiring and a short copper wire, known affectionately as a “pig tail”, presumably because the copper wire is short and curly.  This copper pig tail makes the connection between the old wire and any new electrical devices safe, and costs less than $1000 per unit in materials and labour depending on the number of electrical devices present. 

It’s Simple to fix!  I believe what is actually happening with aluminum wiring is that insurers have come to terms that the bond market is going to stay low for the foreseeable future,  and so are using trumped up risk factors (like aluminum wiring) as an excuse for obscene increases in rates, and to make changes to policies to eliminate insurable risks.  One of our insurance companies we’ve been with for years decided to withdraw from underwriting all risk except for brand new buildings in AAA rated markets. They looked for any excuse to drop a client they’ve had for years.  New requirements are being sent out before renewal to the point that insurance wouldn’t be required at all.  For instance, in my rental houses I’ve seen request that every unit must have fire extinguishers mounted in the kitchen, that closers be installed on all exterior doors, limits have been introduced to the age of perfectly serviceable equipment like water tanks and furnaces that have plenty of economic life remaining, and in one case the insurer even required for a buildings to be rewired.  

 

The fact this is all happening across the hundreds of insurers in Canada sure smells like collusion, but it probably isn’t.

More likely is that insurers are acting rationally in an irrational situation to preserve shareholder profits. it’s getting close to a time where if costs continue to rise, it will make sense to self-insure. Maybe insurers will get the competitive bug before then and start competing again in the next few years, but prices rarely drop so I am not holding my breath.  More likely is government will step in with yet more regulation when there is enough public outcry, even though regulation with unintended consequences is what got us in this mess in the first place. 

So in my opinion, risk to physical buildings hasn’t increased, and what is actually happening is insurers have seen increased claims, but they’ve actually taken a beating to profits because of such low bond yields for such a long time.  Insurers are handcuffed by capital reserve requirements are enforced on them by a bygone era where bonds were deemed “safe.”  In my view, it’s part of the problem with an ever growing nanny state, because regulation frequently has unintended consequences. 

Thankfully for my shareholders, the benefit of the bond market’s influence on low cost of borrowing outweighs the drag on the expense side of the income statement.  Furthermore, multifamily income have proven to be very stable, even during the pandemic.

 

 

If you’re buying a building in the future, be sure to be careful to negotiate a large discount on a building with aging components. 

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