U.S. RMBS and CMBS exposure to rising property insurance premiums is not a key rating driver in S&P Global Ratings' credit analysis, given the various mitigating factors embedded in our criteria for those sectors. In the RMBS transactions we rate, several structural features mitigate the meteoric rise in homeowner insurance premiums, including certain representations and warranties from the mortgage originator or representation provider, the geographic diversification of the loans underlying the transactions, the fact that insurance premiums are typically a small component of the borrower's overall monthly payment, and the servicers' backstop of insurance for uninsured or underinsured loans. For CMBS transactions, the risks are structurally mitigated at the property level with the use of stringent property insurance, at the loan level with monthly reserves to ensure insurance funding, and at the issuer level with mechanisms in place that limit disruption risks.

The Impact On Insurers

Natural catastrophes and physical risks, particularly acute hazards (hurricanes, floods, wildfires, etc.), are common threats to U.S. property and casualty (P&C) insurers. While inherently unpredictable, the frequency and severity of these events have led to outsized financial losses and rising premiums. As a result, homeowner and commercial property insurers are among those most susceptible to physical risk claims. S&P Global Ratings estimates that home and office insurance claims rose 5.7% year over year to $148 billion in 2021 (as measured in direct premiums written). Meanwhile, average annual insured losses attributed to natural catastrophes (affecting all property-related insurance) increased to approximately $52 billion in the 2017-2021 period from $21 billion in the prior five-year period, according to the Insurance Services Office (see chart 1).

Chart 1

The impact of physical risks on U.S. P&C insurers is complex. Insurers face increased loss volatility from environmental-related physical risks, such as higher wind speed intensity, more severe precipitation, convective storms, and costlier secondary perils that result in higher insured loss damage. They also face the risk that regulators could impose restrictions on policy nonrenewals and limitations on premium increases, which may ultimately hurt their bottom line.

We believe insurers will continue to demonstrate pricing discipline and monitor growth exposure by actively controlling risk accumulations. This would help them mitigate the impact of physical risks on their credit fundamentals. However, higher premiums and policy nonrenewals could lead to affordability or other operational pressures on other asset classes, including RMBS and CMBS.

The Potential Impact On RMBS

To protect their collateral, residential mortgage lenders may require borrowers to maintain insurance coverage on the property and dwelling against fires, severe storms, hail and sleet, hurricanes, floods, and other natural catastrophes. Although the rates vary by state and region, U.S. homeowners (and other) insurance premiums have increased significantly in the past five years due to intensifying environmental physical risks, rising home values, and higher replacement material costs due to supply chain disruptions.

Rising premiums' relatively small size offsets the impact on RMBS borrowers' creditworthiness

In our credit analysis for securitized pools of U.S. residential mortgages, we assume homeowners insurance premiums accrue during the foreclosure and liquidation period, thus affecting the loss given default (loss severity) component of our loss projections on the loans. In RMBS transactions, servicers typically advance insurance premiums (and property tax payments) to preserve the trust's interest in the property, which the servicer then recovers upon liquidation, reducing proceeds to the trust. For certain RMBS, we assume annual insurance and property tax of 1.25%-3.00% (as a percentage of the property value before the application of any rating-specific market value decline or forced sale discount), based on the state where the property is located.

Insurance premiums at the time of loan origination can also affect the foreclosure frequency component of our loss projections via the borrower's total debt-to-income (DTI) ratio, which is one of several loan-level factors we use to estimate a loan's likelihood of defaulting. Higher insurance costs can result in higher DTIs to the extent wage (income) growth fails to keep pace, which could affect borrowers' creditworthiness. However, since homeowners insurance is typically a small component of a borrower's overall monthly payment, rising premiums have a limited effect on our foreclosure frequency assumptions.

To assess the credit impact of rising insurance premiums on the U.S. RMBS transactions we rate, we conducted a sensitivity analysis on a sample of RMBS transactions, assuming significant spikes in insurance premiums (double in some cases), and adjusted our foreclosure frequency and loss severity assumptions accordingly. The corresponding impact on loss projections was generally within a rating notch or so. We believe the approximate one-notch difference under this highly stressed scenario, in which insurance premiums and taxes double with no growth in wages, demonstrates the resilience of U.S. RMBS creditworthiness to this particular risk.

Geographic diversification boosts RMBS risk mitigation

Although insurance may mitigate natural catastrophes and environmental physical risks, many perils may not be covered in higher-risk areas. Most RMBS transactions also benefit from significant geographic diversification, which reduces their exposure to acute climate events.

We account for geographic concentrations beyond certain thresholds in our credit analysis for certain RMBS by increasing our pool loss projections accordingly. Despite brief increases in delinquency levels from disaster-related forbearance, U.S. RMBS transactions have demonstrated resilience to environmental physical risks over the past several years, and some of the major storms did not have any direct impact on our ratings.

To assess the general geographical exposure of residential dwellings, we plot data from a large and highly diversified mortgage pool containing loans predominately secured by single-unit dwellings (see chart 2). We ranked the represented geographic regions (based predominately on metropolitan statistical areas) by loan count exposure (high, moderate, and low) and proxy dwelling exposure (high, moderate, and low). We noted that California and Florida accounted for 15.2% and 6.3% of the loans in the pool, respectively. Both states also experienced significant environmental physical risk events in 2021, including wildfires and hurricanes. While some areas in California and Florida face higher exposure to acute climate events, geographic diversification at the pool level can mitigate the overall negative effect these events may have on insurance premiums and RMBS performance.

Chart 2

Certain structural features mitigate residential uninsurance and underinsurance risks

Besides the effect of higher insurance costs on borrowers' creditworthiness, another concern is that insurance companies may stop writing policies in areas with elevated exposure to physical risks, thus preventing some borrowers from renewing required insurance coverage.

Homeowners insurance can mitigate incremental losses on RMBS if the underlying properties are damaged by physical risks that are insured under the policies. RMBS transactions typically contain representations and warranties from the originator (or a relevant representation provider) that all mortgaged properties in the pool are covered by a valid hazard insurance and, as appropriate, flood insurance policy at the time of securitization.

Because insurance policies are typically renewed annually, residential mortgage servicers are generally required to regularly monitor and confirm that there is an active insurance policy on the mortgaged property, and that there are no outstanding tax payments that could result in tax liens superior to the mortgage. Otherwise, the servicer could apply a "forced placed" policy to protect its interests in the property. The servicers generally also maintain "blanket mortgage impairment policies" that cover underinsured and uninsured borrowers' policy lapses, as well as the dwelling.

Regulations and government support also help minimize loss

Since housing is a basic human need, the housing market is highly regulated and likely will continue to benefit from government support during times of stress. For example, after Hurricane Katrina, the federal and state governments intervened to keep insurance companies active in providing coverage to affected areas. Each state has elected or appointed insurance commissioners, whose main duties include serving as consumer protection advocates and insurance regulators that work with insurance companies and provide incentives to not leave areas for the social good. Further, states and federal governments can institute moratoriums that prevent insurance companies from leaving an area until new insurance can be provided by a specific time.

The Potential Impact On CMBS

One major difference between business-to-consumer models (such as residential real estate) and business-to-business models (such as commercial real estate) is that the former is much more scrutinized and regulated. As a result, headlines evidencing the difficulties homeowners face in obtaining insurance quotes in certain parts of the country may be less true for commercial real estate.

Insurance is undeniably becoming more costly

However, commercial real estate properties are also facing rising insurance costs. We looked at a sample of 975 office property loans from U.S. CMBS transactions rated by S&P Global Ratings in the 2017-2021 period (see chart 3). Our research shows that insurance premiums have soared approximately 74% since 2017, with a vintage average of $0.80 per sq. ft. in 2021 versus $0.46 per sq. ft. in 2017 (based on the S&P Global Ratings net cash flow underwritings established at closing). Unsurprisingly, California and Florida registered an even larger insurance rate increase of 103% over the same period. While we consider the sample size to be quite representative of the office sector (less than 100 office loans were excluded from the study due to insufficient data), we also have no fundamental reasons to believe other property types performed any differently.

Chart 3

With a compounded 12% annual growth rate, insurance premiums are rising two to three times faster than the already high inflation rate. The data show that pricing recalibration first occurred in states more exposed to physical risks, such as California and Florida (at least since 2017), before generalizing across the nation over the past two years. Climate change, based on the record number of billion-dollar weather and climate disaster events, anchored the shift in pricing. However, high property values and high property replacement costs (due to certain consequences of the COVID-19 pandemic, including rising material costs, labor shortage, and supply chain disruptions) have compounded the skyrocketing cost of insurance.

Commercial leases structurally mitigate financial risks

Although the question of insurance affordability remains up for debate, premiums are still typically a small cost relative to other property expenses and are generally recovered from the tenants. Therefore, climbing insurance costs alone are unlikely to have significant influence on property net margins or drag down property values.

Although on the rise, insurance premiums tend to remain a small cost contributor (generally less than 5.0%) relative to the other expenses needed to operate a property (e.g., real estate tax, utilities, and repairs and maintenance). This has the net effect of diluting the relative high increase in pricing.

More importantly, the insurance cost is generally passed on through to the tenants. Depending on the nature of the lease in place, tenants will either pay the cost of insurance (in the context of triple net leases) or the increase cost (e.g., with the base incorporated in the initial rental rate for modified gross leases), or agree to pay future rent step-up to the property owners to compensate them from increasing costs.

From a tenant's perspective, the rising cost of insurance may not be a major concern because insurance accounts for less than 2.0%, on average, of what tenants pay to occupy their spaces. A look-through analysis (which compares the cost of insurance to the tenant's underlying operating revenues) would likely further highlight the point that while insurance is necessary to protect asset value, it might not be the most critical cost center in the greater scheme of things.

CMBS deal structures further mitigate disruption risks

Given the importance of insurance coverage, borrowers are contractually required to obtain and maintain adequate insurance coverage during the entire life of the loan. Failure to maintain insurance coverage is a loan event of default that could lead to loan acceleration and potentially foreclosure. As a result, borrowers must renew their initial insurance policies periodically, and they are typically required under the loan documentation to set aside monthly reserves from the property cash flow to fund upcoming insurance premiums to ensure funding. This process is closely monitored by servicers (or special servicers) who review insurance certificates confirming renewal.

Further, U.S. CMBS transactions limit operational risks by allowing servicers to directly fund insurance costs, should a borrower fail to maintain its insurance coverage. Those advances (and the associated interests) rank ahead of the certificates to ensure property value preservation.

Ultimately, The Impact On RMBS And CMBS Is Minimal

We believe soaring property insurance premiums from environmental physical risks will have a minimal credit impact on the U.S. RMBS and CMBS we rate. Our view reflects the structural mitigants the transactions generally have regarding insurance policies, the insurance premiums' relatively small amount compared to the loan value, and the transaction participants' (e.g., the servicers) financial interest in protecting the properties from insurance-related risks. Moreover, today's push to address physical and climate transition risks, combined with tomorrow's advanced technologies, should certainly help the market to refine and improve insurance pricing.