Property Insurance Coverages During Inflationary Times

This article is about raising public awareness of the problem of under- insuring real property that occurs over several years because of upward inflationary adjustments in construction costs and real estate prices. This is a national problem that few property owners are giving much thought to. Insurance companies are somewhat protected because they can pay out to the policy limits before the upward pricing pressures that may have been established years ago and be done with the problem.

The insurance industry is like a cartel. There are only a limited number of companies allowed where the admitted members can draft regulations in their favor but will be regulated by the California Department of Insurance or other similar state agencies for other states.

General agents are agents of the insurance company rather than the policy holder. Insurance brokers are dual agents who represent both the company and the insured. Failing to adequately counsel their clients as to the proper insurance products, alternative insurance products, and corresponding add- on endorsements is a breach of fiduciary.

Negotiating a claim to reasonable satisfaction may require expensive litigation or binding arbitration against mammoth sized companies with very deep pockets. The insured parties may be forced to pay legal costs and suffer the delay of reconstruction of the building for an extended period of time.?

As an example, a borrower, while completing the loan application, may object to the lender’s requirement that the subject property be insured up to the full 100% replacement cost coverage of the building (security property) and?appurtenant structures. The borrower might suggest coverage of 50% of replacement cost because the value of the property may or may not reflect building adequate coverage for the replacement cost of the improvements. Borrowers should rely on counsel from his/her insurance broker to guide them for appropriate decisions regarding the types and amounts of coverage, alternative coverages, and appliable endorsements.

A borrower may be focused on saving money but be uninformed or ill informed as to the negative financial unintended consequences. If the borrower does not follow the recommendations of his mortgage broker or his qualified insurance agent or broker, then bad things may happen. It may not be until a time-period has passed with compounded inflation that the property owner experiences a hazard loss, tenders a claim to the insurance company and discovers the condition of massive under-insurance. The insurance company is fully aware that they are protected from this problem of under-insurance because of their policy limits.

Inflation causes prices of building materials, appliances, heating & air- conditioning, municipal approvals including revised building codes, and labor to go up substantially and over time this process compounds prices.

Whether intentional, uninformed, or negligence by the borrower’s insurance agent or real estate or mortgage broker the insured party may find themselves in a position of under-insurance and having to pay for portion of the repairs and/or reconstruction costs for the loss. Many owners may not have the financial strength to pay for the shortage. The consequence may be to walk away from the property and hand the keys to the lender.

I question whether the property insurance industry participants, including insurance agents/brokers and real estate agents/brokers are being vocal enough about this national problem!

Replacement cost coverage (RCV):

The amount of money that it would require to replace the damaged or destroyed property with the same or similar substitute quality as it was originally built. This may be difficult if not impossible. Insurance for enhancements, betterments, building codes and current zoning ordinances to?bring the property up to today’s standards require a different form of insurance or endorsement and are not included in the definition of insurance replacement cost.

The insurance definition of replacement cost is hypothetical and not a reality because “same, and/or substitute quality of materials” is so radically different over an extended time that it is probably not economically feasible. Because of these differences replacement cost insurance may not be quite understood by the public who purchases insurance policies as a protection mechanism.

Assuming that a property was built in 1946 the policy contemplates reconstructing the building to those same 1946 standards. Replacement cost verbiage in the insurance policy does not contemplate current codes, ordinances, and regulations, designs, and available materials. Older properties may be characterized by now obsolete materials such as asbestos and galvanized and lead plumbing. An example of upgrades not covered would be replacing 1946 installed single-pane windows with aluminum frames with modern double insulated low-E glass panes with vinyl-frames, upgraded anodized aluminum-frames, or wood-frames.

Structural designs, engineering requirements, building materials, and add-on standards have changed dramatically over the last 50 years but accelerated over the last 20 years. Most of these new requirements are government driven mandates to the point where current insurance products may not work correctly or are inadequate. Insurance carriers may not be willing to write policies to cover all the new requirements. An insurance policy is not designed to replace the need to invest additional capital to upgrade or bring the property into current compliance with the idea of raising rents and enhancing value.

Interested parties may visit www.insurance.ca.gov for an overview of insurance products and definitions.

Extended replacement cost coverage:

This type of insurance is additional, more extensive, and expensive protection. The coverage protects the insures against sudden increases in materials or construction cost. Some carriers will offer extended replacement options as?an endorsement that may cover up to an additional increase of 20% to 25% of the replacement cost up to the policy limits. 20% or 25% may not be enough to pay for all the higher costs and new government mandated requirements.

Zoning and building ordinance Insurance:

This form of coverage is usually by policy endorsements. This additional coverage is intended to cover to cost of repair or reconstruction that requires upgrades or updating so that it meets current building codes and current building standards. Examples may pertain to weather, fire safety, wiring or handicap accessibility. Some forms are called Improvements and Betterments Insurance Coverage. These coverages vary in what they are called, what is covered, and what is excluded with different insurers.

Actual cash value policies (ACV):

A cheaper form of insurance coverage is available but not recommended. In almost all cases a (ACV) policy is a bad idea. An insured party may choose coverage that is referred to as actual cash value coverage. With this coverage a loss would be calculated to include the depreciated fair market value of the damaged or destroyed dwelling at the time of the loss and up to the policy limits. In other words, replacement cost minus depreciation of the damaged property (ACV=replacement cost less depreciation). It represents the dollar amount that you would expect to receive by selling the property on the open market. This form of insurance may significantly alter the underwriting by lender(s).

This form of coverage is more common for older commercial and industrial properties.

Policy exclusions: Most insurance carriers have policy exclusions including but not limited to ordinance or law, total pollution exclusion, asbestos, lead- based paint, earthquake, earth movement, acts of war, mold & fungus, etc. Also, damage due to poor maintenance or workmanship, general wear & tear, pest infestations, power failure, nuclear hazards, government actions, intentional loss by the insured, and home-based business liability is not covered. Carriers have different exclusions and what they will cover by separate policies and add-on endorsements.

Coinsurance provisions:

Many insurance policies in both residential and commercial have language referred to as a coinsurance provision which covers the issue of under- insurance. A coinsurance clause used in property insurance contracts ensures that the policyholder must insure their property up to an appropriate value so that the insurer receives a fair premium for the risk. Coinsurance clauses require that policy holders insure up to 80, 90, or 100% of the replacement cost of the structure(s) and appurtenant(s).

Coinsurance penalties will be applied on claims for under-insurance and will differ with companies and policy types. Effectively, a coinsurance penalty triggers a contractual requirement that the insured party pay a portion or penalty in their own financial loss using a calculation formula in the policy. Some insurance companies provide step-up coverage endorsements to reflect higher replacement cost amounts due to inflation.

Whether or not the policy contains a coinsurance penalty provision the insured party could find themselves being significantly underinsured in the event of a hazard claim and as a result having to pay for a portion of their own loss and a portion the cost of reconstruction, including betterments and enhancements. The insurance company may pay up to the policy limits and leave the under-insured party hanging out for the remainder.

This circumstance of under-insurance is more prevalent now than it has been in the past because of the upward cost pressure caused by inflationary increases in construction costs. Lumber has gone up dramatically. Materials and labor have gone up dramatically. Municipal approvals and building standards/codes are much more stringent. Add-on municipal fees have gone up.

A mortgage broker/borrower or insurance provider who calculated $200 per square foot a few years ago may find that replacement cost has doubled to $400 per square foot not counting the land value. Housing replacement cost estimates may be from $200 per square foot for entry level production homes up to $1,000 to $1,500 per square foot for high-end customs.?

Lenders and mortgage companies may want to audit their loan portfolios to ensure that property coverages are adequate to offset inflation. Lenders may want to discuss with insurance carriers about methods and sources of data for calculating current replacement costs. Most insurers as well as appraisers use Marshall & Swift cost data to calculate cost of construction.

Deeds of trust usually contain language that require replacement cost coverage: Here is an example:

Insurance (“Building Insurance”) on all buildings, fixtures and improvements located on the Trust Property against fire and “special perils” (including “ordinance or law coverage”), in amounts at least equal to the greater of:

(A) the full replacement cost thereof (without deduction for depreciation) as such replacement cost shall be determined from time to time at the reasonable request of Beneficiary; or

(B) unless prohibited by law, the unpaid principal amount of the indebtedness. The Building Insurance shall include a coinsurance waiver or agreed amount endorsement for zoning and law coverage and betterments and enhancements coverage. Such insurance shall, during the course-of- any-construction of additions to the improvements, be on Special Form Builder’s Risk 100% Completed Value Non-Reporting Form or other form approved by Beneficiary(s).

This language should be drafted by the lenders counsel.

Appraisal process:

As part of the loan application process an appraisal will be obtained to determine appraised value of the entire property. The lender/mortgage broker may request that the appraiser supply a replacement cost analysis using today’s standards segregating the value of each component included in the replacement cost of the dwelling, land (opinion of site value,) appurtenances, garage, site improvements, and landscaping. Usually, the appraiser will subtract depreciation for wear and tear (physical, functional, external) coming up with a NET ADJUSTED INDICATED VALUE BY COST APPROACH.?

Lenders may use the appraiser’s calculations to determine the required replacement cost estimate of all the real property components excluding the value of the land parcel. The lender may use this estimate of replacement cost to determine the amount of required coverage.

For a 2000 square foot home current replacement cost may be $800,000, but the depreciated value may be adjusted down to $400,000. Depreciated value considers accumulated loss of value from wear & tear and deterioration. A replacement cost policy may pay out the entire $800,000 while the actual cash value policy may pay only the $400,000.

Sometimes there may be a deviation/conflict between what the appraiser’s estimate of the replacement cost and what the insurance company representative suggests. The required amount(s) of coverage may need to be negotiated between the lender, mortgage broker, borrower, and insurance company. The difference in calculations may be substantial.

Let’s assume that the appraiser believes that the replacement cost is $1,000,000 but the insurance carrier agent says that it is $600,000. Even though this is a substantial difference the lender who is originating/making the loan will first look at the amount of the loan balance and the value of the land parcel segregated from the structures to determine risk of loss. Let’s assume that the new loan is $700,000. The lender may agree that a $700,000 insurance policy will be enough coverage providing the insurance carrier includes an endorsement that if the cost is higher because of current codes and zoning changes that the higher cost will be covered. This is sometimes referred to as betterments and enhancement or code compliance coverage as discussed above.

The cost difference between replacing a structure as it was originally constructed and replacing with structure with updated current requirements could be as much as 100% higher, or more. This will most likely require changes in property configuration based upon front/side setbacks, construction materials, zoning changes, and parking requirements, etc.

A betterments and enhancements endorsement to a replacement cost coverage policy is an add on, or addition or additional insurance.?

Distinction between the definition of replacement cost in the insurance industry and the appraisal industry:

Insurance industry: Replacement cost is the amount of money that it would take to replace the damaged or destroyed property with the exact same quality with original or substitute materials as it was originally built but with today’s prices. It assumes the use of like-kind and similar quality materials, construction designs, and quality of workmanship as when it was originally constructed. Enhancements, betterments, zoning codes and zoning ordinance compliance are not included in the replacement cost definition.

Appraisal Industry: Replacement cost is the cost to construct or replace the structure at a given time, usually current. It includes the existing structure with equal quality and utility, using prices for labor, materials, overhead, profit and fees at the time/date of the appraisal. The appraiser assumes that reconstruction will be done with current standards with substitute products of “like kind” and/or “equal utility.”

Some lending industry participants get confused about these definitions and their application to the loan process.

Property insurance is a complex subject and made more complex by government overreach. My comments are not all encompassing. Any owner/borrower or lender/mortgage broker should consult with a highly competent personal line or commercial insurance specialist to guide them to appropriate coverages and contingent liability coverages.?